Monthly Financial Jargon: Tax-Loss Harvesting

The world of finance and investments is notorious for its extensive use of jargon. With a goal to enhance financial literacy and make the world of money more transparent, we have our “monthly jargon” articles that focus on debunking financial terms that are often used sans explanation. This month, we’re focusing on a strategy that can help you reduce your tax liability at the end of the year: tax-loss harvesting.

What is Tax-Loss Harvesting?

Tax-loss harvesting, also known as tax-loss selling, refers to the selling of securities at a loss to offset a capital gains tax, the tax on the profit from an investment that is incurred when you sell the investment. In the world of investing, not every investment is going to be a winner, and tax-loss harvesting allows you to take advantage of a losing investment. With tax-loss harvesting, you may be able to use your loss with a certain investment to lower your tax liability and better position your portfolio for the future; in other words, tax-loss harvesting essentially allows you to turn investment losses into tax breaks. This strategy helps you lower your tax bill by selling underperforming investments at a loss to deduct those losses on your taxes. By deducting those losses on your taxes, you can offset some or all of the capital gains tax that you owe on the better-performing investments that you sold for a profit. In other words, tax-loss harvesting helps you minimize your capital gains tax liability by offsetting the amount of gains you have to claim as income.

How Does Tax-Loss Harvesting Work?

Because the idea behind tax-loss harvesting is to offset taxable investment gains, tax-loss harvesting only applies to investments held in taxable accounts. Tax-loss harvesting works as follows: you identify an investment that is underperforming and decide to sell it, then you use that loss to reduce your taxable capital gains and offset up to $3,000 of your ordinary income. Lastly, you reinvest the money from the sale of the underperforming investment by purchasing a different security that fits your asset-allocation needs.

For example, let’s say you are reviewing your portfolio and notice that certain holdings have risen significantly, while other holdings in a different sector have sharply underperformed. These performances have thrown your portfolio off balance, so to realign your portfolio with your desired allocation, you sell some of the gains from the overperformers and use those funds to rebalance. This is where tax-loss harvesting comes into play: If you also sell some of the investments that have underperformed at a loss, you can use those losses to offset the capital gains you realized by selling the overperforming investments, thus reducing your tax liability on those gains. If your losses are greater than your gains, you can use the excess losses to offset up to $3,000 – $1,500 for married filing separately individuals – of your ordinary taxable income in a given year, and any amount over the $3,000 or $1,500 threshold can be carried forward to future tax years to offset future income.

The Pros and Cons

Tax-loss harvesting is an important tax-smart strategy for investors to consider at the end of the year. Through tax-loss harvesting, you glean investments in your portfolio to sell at a loss, and then use that loss to lower and potentially eliminate the taxes you are required to pay on gains made throughout the year. Keep in mind that you do not need to have a huge portfolio to benefit from this year-end tax-saving strategy – even if you do not have investment gains to minimize, you can use the losses to offset your ordinary income taxes as well.

However, as with all investment and tax-saving strategies, tax-loss harvesting may or may not be the best strategy for you to leverage. Here are a few things to consider when weighing the pros and cons of tax-loss harvesting for your financial life:

1. Be cognizant of the latest tax rates regarding investments to determine if tax-loss harvesting is a smart choice for you now. Tax-loss harvesting may not be as financially fruitful if you are in a low tax bracket, as some tax rates can make investment losses more valuable for high-income investors. In other words, since the idea behind tax-loss harvesting is to lower your tax bill in the present, the strategy is innately more beneficial for individuals who are currently in the higher tax brackets. If you are presently in a lower tax bracket and anticipate being in a higher tax bracket in the future, you may want to wait and implement tax-loss harvesting in future years when the strategy will bring more savings.
2. Be aware of the wash-sale rule. This IRS rule states that if you sell an investment to realize losses and to deduct those losses for tax purposes, you cannot buy back that same asset or another similar asset for 30 days. Note that you cannot bypass this rule by buying the asset back in another account.
3. Tax-loss harvesting done in the context of rebalancing your portfolio is the best-case scenario. Rebalancing your portfolio helps you realign your risk, and as you rebalance, you will look at which holdings to buy and sell based on their performances. Pay attention to the cost basis – the original purchase value – of your investments, as these values will help you determine the gains or losses for each asset.
4. Be mindful of short- vs. long-term capital gains. Short-term capital gains are realized from investments that are held for a year or less, while long-term capital gains are earnings from investments that have been held for more than a year. The key difference between short- and long-term gains is the rate at which these gains are taxed: Short-term capital gains are taxed at your marginal tax rate as ordinary income, while the capital-gains tax rate applies to long-term capital gains and is significantly lower. Short- and long-term losses should be used first to offset gains of the same type; however, if your losses of one type exceed the gains of the same type, you can apply the excess loss to the other type.

Final Points

Incorporating tax-loss harvesting into your year-end tax planning strategies is prudent as an investor. Remember, tax-loss harvesting and portfolio rebalancing complement each other well, as rebalancing allows you to ensure your portfolio stays aligned with your risk profile and investment goals and to evaluate underperforming investments that could be good candidates for tax-loss harvesting. If you’re considering this tax-saving strategy, you have until December 31 to complete all of your harvesting – there is no grace period. Overall, keep in mind that it is not necessarily the best decision to sell an investment exclusively for tax reasons; however, tax-loss harvesting can absolutely be a useful tool for your comprehensive financial planning if done properly. Be sure to consult your financial advisor and tax advisor before implementing this strategy to make sure it is right for you.