For investors in stocks and bonds, tax-loss harvesting can turn losers into partial winners.
But what is it, exactly? In short, it's a popular tax-minimization strategy under which investors sell losing investments and then deduct those losses on their tax returns. Most investors employ these tax-smart moves in December, but you can use it year-round.
What Is Tax-Loss Harvesting and How Does It Work?
This strategy can work in two ways. First, investors use the strategy to offset capital gains taxes earned on their other investments. The offset amount is unlimited.
But if your investment losses exceed your capital gains, you can apply up to $3,000 of your losses to lower your income taxes (on salary or hourly wage, etc.) a year. Whatever cash is left over can be used the following year.
As an example, let’s say you’re on track to lose $10,000 in Apple stock this year and have no other profits from capital gain sales to report. You can take a $3,000 deduction on your 2018 on your income taxes, then use the remaining $7,000 again (or carry it forward) to offset capital gains or income in future tax years. It’s the gift that keeps on giving.
Also, tax-loss harvesting goes hand-in-hand with “rebalancing” the portfolio — another strategy that forces you to sell assets freeing up money that can be invested again according to your core investment objectives and risk-tolerance levels.
What Are Capital Gains?
When you profit from the sale of financial and physical assets like stocks, a house, or your granddad’s farmland, you earn a capital gain that, in most cases, is taxable income. How big of a “capital gain tax” hit you take depends largely on how long you held the asset before selling.
As a result, the tax bite could be quite nasty for some investors who aren’t patient.
So as not to be confused by mixing apples with oranges, this column takes a look at how capital gains taxes affect stocks, mutual funds, and exchange-traded funds (ETFs). A different set of rules governs capital gains taxes on home and property sales. That’s for another “What Is” column.
What Are Capital Gains Taxes?
Whether you are a Wall Street hotshot or a first time investor, the Internal Revenue Service (IRS) taxes capital gains in two easy to understand ways: long term and short.
Long-Term Capital Gains Tax
This is the friendlier of the two taxes. It applies against the profits earned from the sale of an asset held for more than a year. There are three tax rates, and the one that you fall into depends on your taxable income and filing status. The rates are zero, 15 percent, or 20 percent.
Short-Term Capital Gains Tax
This applies when you sell your asset for a profit (a quick one) instead of holding it for at least a year. There are seven tax rates on short-term capital gains, which are the same tax rates as income tax brackets: 10, 12, 22, 24, 32, 35, and 37 percent.
Getting the Most Out of Tax-Loss Harvesting
Indeed, those short-term rates on the higher end seem like a pretty steep penalty. Many active, wealthy investors who frequently buy and sell stock, trade in other more complex investments, and control large investment portfolios are naturally the most susceptible to being hit with capital gains taxes.
For seasoned investors, tax-loss harvesting is an invaluable tool they use year after year.
But small-time investors can get some use out of tax-loss harvesting, too. And whether you’re a big fish or a little one, you might want to get help from a financial advisor.
Another Example of How Tax-Loss Harvesting Works
Let’s say that before the financial crisis of 2008–09 and the rise of social media, you owned several shares in a well-known technology company. You were forced to sell and earned a short-term gain of $10,000 — and the very strong possibility of a hefty tax hit.
On the other hand, you lost $14,000 investing in solar-power companies that same year. Under tax-loss harvesting, the $10,000 in gains got wiped out by the $14,000 in losses. You then used the remaining $4,000 to reduce your taxable paycheck income by $3,000. The $1,000 leftover was carried over to lower your taxable income the following year.
Things to Keep in Mind
Tax-loss harvesting is not complicated. But before starting the strategy, it’s best to do some planning and research. Remain aware of the legal restrictions on the strategy so you don’t run into any traps.
Hands Off the Retirement Account
If you have a retirement account like a 401(k) or an individual retirement account, forget about harvesting your investment losses. Those accounts are tax-deferred, meaning your losses cannot be deducted (also, conversely, you don’t pay taxes on investment gains).
Proper Capital Gains Matching
Not all capital gains and losses are created equally, something you’ll have to consider when maximizing your wealth.
When it comes to putting your capital gains and taxes to work, you must offset short-term gains with short-term losses, and long-term gains with long-term losses.
Then if you have only, say, a short-term loss and a long-term gain to report, the IRS will accept that offset. And as mentioned before, you can use any remaining losses after you first offset your capital gains to reduce your taxable paycheck income by $3,000.
Mind the Wash-Sales Rule
Nearly a century ago, tax-loss harvesting was a well-used — and abused — strategy. Investors could sell a losing stock, get a tax break, and then buy back the shares at a lower price while speculating that the stock will rebound.
But some clever investors didn’t have to make speculative bets. They could manipulate prices downward or upward and cash in on those movements.
The federal government put a stop to this and created the wash-sales rule. This mandates that you must wait 30 days before and after the sale of a financial security to repurchase any stock or shares in mutual funds and ETFs. If you violate the rule, you lose your tax-loss deduction.
Final Thoughts: Tax-Loss Harvesting for All
For those just starting to save and invest, tax-loss harvesting may seem like a far-off thing, some tax-avoidance tool designed to help rich investors get richer at the non-investing taxpayer’s expense. But harvesting your tax losses is a strategy that is open to everyone — and you should use it.
Right now, I’m doing a little tax-loss harvesting myself with the help of my financial advisor, albeit with mixed feelings. I have no capital gains to report this year, just losses, so I’m using the strategy’s fourth and lowest stage — or the one that offers the least tax-savings bang for the buck.
After recouping my losses, I’m not sure if I’ll get back into stocks, even if prices fall further. I may instead channel my investment elsewhere. Regardless, at least I know I can write off $3,000 each year well into the 2020s, showing how tax-loss harvesting can make the best of an otherwise non-lucrative situation.
Additional background information for this article was provided by Gary Massey, CPA and Managing Director of Massey and Company.