Tax-loss harvesting allows investors to minimize capital gains taxes on investments. It can also offset some of your ordinary income.
This strategy has gained popularity in recent years, but how much does it actually help? As with most investing questions, it depends.
Still, there are some general ideas that can help you begin to understand the strategy. We’ll cover those and more in this post.
What is Tax-Loss Harvesting?
Tax-loss harvesting occurs when investors sell certain securities at a loss. In doing so, investors can offset taxes on both capital gains and income.
So, what does this mean? These losses can be written off on your tax return. Thus, you end up with a net benefit even though you sold securities at a loss.
This strategy is a long-term one and is only relevant for taxable brokerage accounts. Retirement accounts, such as a 401k or IRA, grow tax-free, eliminating the need for tax-loss harvesting.
Tax-loss harvesting can be used to reduce your tax liability in two ways:
- Offset capital gains on investment returns
- Reduce tax on ordinary income by up to $3,000
One of the nice things about capital gains is you can carry gains forward into future tax years. If you have $10,000 in losses one year but only write off $5,000, you can carry forward the other $5,000 to any tax year in the future.
Short-Term Capital Gains vs. Long-Term Capital Gains
Another thing that’s important to note about capital gains taxes is there are different tax brackets for long-term capital gains and short-term capital gains.
- Short-term capital gains are realized when selling investments after less than one year.
- Long-term capital gains are realized when selling investments after more than one year.
Short-term capital gains are taxed as regular income, but long-term capital gains have their own tax brackets.
Here are the long-term capital gains tax rates for 2021:
Married, Filing Jointly
Up to $40,400
Up to $80,800
$40,401 to $445,850
$80,801 to $501,600
Because there are separate tax rates for short-term and long-term capital gains, there are many possible tax-loss harvesting strategies.
Long-term capital losses affect long-term gains first, and then short-term gains. Short-term gains work the opposite way.
It’s possible to combine the two, such as by harvesting short-term losses against long-term gains. However, your short-term losses would be applied to short-term gains first (if you have any).
Either way, the benefit of tax-loss harvesting is it allows you to reduce your overall tax liability. If you are single or married filing jointly, you can use your capital losses to offset up to $3,000 or ordinary (non-investment) income.
For married, filing separately tax returns, the income offset is up to $1,500.
Any additional losses can either be used to offset additional gains - or carried forward for future tax years.
Additional Benefits of Tax-Loss Harvesting
One of the biggest benefits of tax-loss harvesting is how it can affect your long-term returns. We tend to focus on the numbers we see today, but that is not where the greatest potential benefit lies.
This is especially true for those who expect to have less income in retirement. If you are in a high tax bracket today, you can and can use tax-loss harvesting to defer some of your taxes.
Then, if your income is lower after you retire, your tax brackets will be lower, too. Withdrawals are taxed as income, but if you draw down less than you make today, you’ll pay less in taxes.
There are a few other things you should keep in mind before tax-loss harvesting.
Tax-Loss Harvesting Deadline
The deadline for tax-loss harvesting doesn’t line up with filing your individual tax return. Instead, you must have tax-loss harvesting completed by the end of the calendar year - December 31st.
That being said, if you want to fully optimize your tax-loss harvesting, it may be a year-round strategy.
Be Mindful of Fees
Thus, you’ll have to keep an eye on trading commissions and any other administrative fees your broker may charge. Some traditional brokers may charge fees up to $30 for a single trade.
The Wash-Sale Rule
The wash-sale rule prohibits investors from purchasing “substantially identical” security, option, or contract, within 30 days before or after selling your security at a loss.
Although most investors tax-loss harvest to reduce their tax bill, the IRS won’t allow you to sell a security at a loss and then immediately buy it back solely to harvest losses.
This means that if you sell a security at a loss, you’ll have to wait at least 30 days to buy it again.
Another option is to buy an investment that isn’t similar to the one you just sold. For example, if you just sold a total-stock market index fund, you could replace it with a sustainable investment.
After 30 days elapses, you then have the option to either sell the “replacement” investment or simply keep it in your portfolio.
Where to Do Tax-Loss Harvesting
There are many options for tax-loss harvesting. You can work with a financial advisor who can help with it, or try doing it on your own if you are more experienced.
However, keep in mind that tax-loss harvesting is most beneficial for those who are currently in a high tax bracket. If you expect your income to be lower in retirement, you may not benefit as much from tax-loss harvesting.
Tax-loss harvesting helps investors save money on taxes by selling securities at a loss to offset capital gains. It also allows them to write off up to $3,000 of ordinary income. For couples married, filing separately, that amount is $1,500.
Long-term capital gains tax on investments held for more than one year are lower than short-term capital gains.
Short-term capital gains are taxed as regular income and adhere to the same tax brackets as income tax.
However, long-term capital gains use lower tax brackets, and most investors will owe 0% or 15% on these gains in 2021. Only long-term capital gains above $445,850 (filing single) or $501,600 (filing jointly) are taxed at the 20% rate.
This strategy can reduce capital gains taxes by tens of thousands of dollars for high-income investors.
Just be aware of the wash-sale rule, which disallows similar investments with 30 days of selling at a loss.
And if you want your tax-loss harvesting done automatically, be sure to check out Betterment.