No one likes the idea of losing money in the stock market, but sometimes taking a loss can actually work to your advantage. Tax loss harvesting allows you to realize losses and get a tax break in return, helping you reduce your taxable income or offset gains in other parts of your portfolio.
Here’s how to maximize your benefit from tax loss harvesting and what to look out for so you don’t run afoul of Internal Revenue Service (IRS) rules in this area.
What is tax loss harvesting?
Tax loss harvesting is the process of writing off the losses on your investments to claim a tax deduction on your ordinary income. To claim a loss on your current year’s taxes, you must sell investments in taxable accounts before the calendar year ends, and then report this action when you file that year’s taxes.
The IRS allows you to claim a net loss of up to $3,000 each year (for single filers and married filers jointly) from failed investments — and it’s usually a good idea to take full advantage of this. That net loss of $3,000 could save you $720 in taxes at the 24 percent marginal tax bracket at the federal level and potentially even more savings at the state level.
A depreciation reduces any other capital gains you earned during the tax year, and it’s important to note that the deduction is a “net” loss. For example, you can make $5,000 on one investment and lose $8,000 on another, and you can still claim the maximum deduction of $3,000.
Even if you can’t claim the maximum net loss of $3,000, you can still reduce the value of your winnings and save tax that way. So if you have a profit of $4,000 and a loss of $1,000, you have a net profit of $3,000, saving you taxes on the extra $1,000 you wrote off.
And if your losses exceed that $3,000 maximum? The IRS allows you to roll over those additional losses to future tax years. So if your investments perform well next year and you make some capital gains at that time, you can use previous unused losses to offset those future gains.
Tax-loss harvesting is only valuable in taxable accounts, not in special tax-advantaged accounts such as IRAs and 401(k)s, where capital gains are not taxed annually (or sometimes not at all – in the case of the Roth IRA).
And if you want to reduce your tax bill, you have a number of other ways to do so.
How to take advantage of tax loss harvesting
If you want to use tax loss harvesting for maximum benefit, follow the steps below. It helps to be well organized at the end of the calendar year so that you know exactly how much you need to sell to optimize the strategy.
1. Determine your goal
Do you want to offset only your profits and reach the maximum net loss of $3,000? Or do you want to close a losing position and not have to worry about fine-tuning your debit?
- If it’s the former, you may want to stay invested in a currently losing position that otherwise has a strong future.
- If the latter, you may not care what you earned this year.
If you don’t want to refine your write-off, you can simply sell your losers or an investment you no longer believe in and move on. When it’s time to determine your taxes, you can figure out the gains and losses.
However, if you invest in a fund, it may make sense to realize a loss, book the tax benefit, and then turn around and buy a fund that tracks a similar part of the market. If you do it right, you’ll avoid the wash-sale rule (more below) so you get the tax break now and can still enjoy the potential investment returns.
2. Calculate your profits and losses
However, if you want to narrow your losses and stay maximally invested, you’ll want to calculate your realized gains for the year, as well as what else you could sell by the end of the year. Then you can determine how much loss you need to offset those gains.
For example, if you have realized a gain of $10,000 so far this year and expect to realize another $1,000 by the end of the year, you can expect a total of $11,000 in capital gains. Let’s imagine you’ve already incurred a $5,000 loss from asset sales so far. You have a net profit of € 6,000. So if you want to maximize your net loss for the year at $3,000, you could still realize a loss of $9,000. If you realize a larger loss, you can only write it off in future tax years.
View your brokerage statements and see which investments are showing losses. To maximize your taxable loss, you need to find investments where you have lost at least $9,000. You can use any number of losing positions to reach this figure.
3. Execute the transactions
Once you know how much to sell and which positions you will sell, execute the trades in your trading account before the calendar year ends.
If you want to buy back the position later after claiming a loss, wait at least 30 days to avoid the wash-sale rule.
Many robo-advisors will automate the process for you
Maximizing the tax benefit on your capital losses may require some extra effort, but it still makes a lot of sense for investors to do so. But if you use a robo-advisor to manage your accounts – and robo-advisors offer many benefits at a surprisingly low cost – you can usually harvest tax losses at no additional cost.
Robo-advisors can boost tax loss harvesting and do more than most human advisors could do. For example, robo-advisors use an automated process to maximize your tax savings, and they may check daily to see if they can realize a loss on a fund. Then the robo-advisor buys another but similar fund that mimics the performance of the original, so you get a tax benefit but still own a fund that is likely to perform just as well.
That’s one of the key benefits of a robo-advisor, and many also offer automatic rebalancing as part of the deal. Here are the best robo-advisors for your portfolio.
Three things to keep in mind when harvesting loss
Here are three things to keep in mind when taking advantage of this tax break.
1. Wash sale
Of course, the IRS has put in place some restrictions to prevent you from putting the tax loss harvesting rules into practice. The most notable of these caveats is the wash-sale rule, which prevents you from claiming a taxable loss and then immediately repurchasing the security. And that also applies to your partner: you cannot sell and claim the loss while the partner buys for his own account.
If you want to report a loss on your taxes instead, you (and your spouse) should avoid buying back the losing security for at least 30 days. If you repurchase the security within 30 days, you must forgo the tax benefit. However, you will not lose the tax benefit forever. When you eventually sell the security, you can get the tax benefit back and write off the loss.
2. Long-term losses versus short-term losses
The IRS insists that you offset like against like. That is, your long-term capital losses will offset long-term capital gains first, while short-term losses will offset short-term gains first. It’s an important distinction because capital gains are taxed based on how long you’ve owned the security. Only after you summarize your results can you offset short-term gains with long-term losses.
Long-term capital gains are taxed at special rates that may be lower than what you would otherwise pay for your ordinary income – 0, 15 and 20 percent, depending on your income. These rates apply to assets that you hold for more than one year.
Short-term capital gains are taxed at your normal income rate, which can be as high as 37 percent. These rates apply to assets that you have owned for less than one year.
Brokers will report your profits and losses to you and the IRS. However, their numbers don’t always add up, especially in complicated tax situations, so it may be worth keeping a close record of your transactions.
3. Avoid selling just to get a tax break
It can be easy to sell an asset, like a stock, just to get a tax break – that’s for sure – when the future gain on the stock is anything but certain. This is especially true because stocks can be quite volatile in the short term. But if you’re holding the stock for its long-term potential, and not just for this tax year, you may wonder whether it’s smart to sell at a capital loss.
Stocks are investments that tend to do well over long periods of time, and claiming a loss now could mean selling the stock just as it is about to recover. If there is nothing fundamentally wrong with the investment, you may want to consider keeping it instead of selling it.
Is tax loss harvesting worth it?
Tax loss harvesting is now a way to generate real tax savings by realizing investment losses. The tax savings are a real, tangible benefit for those who go through the process, but there are times when realizing losses can be a mistake. For example, sometimes an investment may suffer temporary losses on the way to outsized gains. There is a fine line between realizing a loss due to an analysis error and selling because you were not patient enough.
Consider the long-term prospects for the investment and whether these have changed since you first purchased the asset. If you still see potential in the investment, you might be better off holding on.
In short
Tax loss harvesting gives you the opportunity to gain a tax benefit on a bad investment, and it’s a good opportunity to offset other taxable gains, especially if you think the investment will never recover. To take maximum advantage, consider reducing your tax burden each year.
Please note: Bank interest Brian Baker contributed to an update to this story.
