Tax-loss harvesting is an investment strategy used by investors to reduce their tax liability by selling investments that have experienced a loss in value. The goal is to offset capital gains and potentially lower the amount of taxes owed. Here’s everything you need to know about tax-loss harvesting, including rules and strategies:
What Is Tax-Loss Harvesting?
Tax-loss harvesting is the practice of strategically selling investments that have decreased in value (realized capital losses) to offset capital gains, both short-term and long-term. By doing so, investors can reduce their taxable income for the year, which can lead to lower taxes.
Rules and Guidelines:
- Offsetting Gains: The primary purpose of tax-loss harvesting is to offset capital gains. You can use capital losses to offset capital gains, reducing or eliminating the tax liability on those gains.
- Wash-Sale Rule: The IRS has a rule known as the wash-sale rule, which prevents investors from recognizing a capital loss for tax purposes if they repurchase the same or substantially identical investment within 30 days before or after the sale. To comply with this rule, you must avoid purchasing the same security or a substantially identical one within this 30-day window.
- Net Losses vs. Net Gains: If your capital losses exceed your capital gains in a tax year, you can use the excess losses to offset ordinary income, up to a maximum of $3,000 per year ($1,500 if married filing separately). Any remaining losses can be carried forward to offset future capital gains indefinitely.
- Long-Term vs. Short-Term: Capital losses can offset both short-term and long-term capital gains. However, long-term losses should be used to offset long-term gains first, as they are generally taxed at a lower rate.
Tax-Loss Harvesting Strategies:
- Year-End Harvesting: Many investors engage in tax-loss harvesting at the end of the calendar year to assess their tax situation and potentially offset capital gains realized during the year.
- Strategic Asset Location: Place tax-inefficient investments (those generating significant capital gains) in tax-advantaged accounts like IRAs or 401(k)s. Keep tax-efficient investments in taxable accounts to minimize taxes while maintaining your desired asset allocation.
- Use Tax-Efficient Funds: Consider investing in tax-efficient index funds or exchange-traded funds (ETFs) that generate fewer capital gains distributions. These funds can minimize the need for frequent tax-loss harvesting.
- Diversification: While tax-loss harvesting can be beneficial, ensure that it doesn’t compromise your long-term investment strategy or diversification goals. Don’t sell investments solely for tax purposes if it conflicts with your overall financial plan.
- Market Downturns: Take advantage of market downturns to identify investments with losses. During these periods, there may be more opportunities for tax-loss harvesting.
- Tax Rate Consideration: Assess your current and expected future tax rates when deciding to harvest losses. The benefit of tax-loss harvesting may vary based on your tax situation.
- Professional Guidance: Tax laws can be complex and subject to change. Consult with Matthew Jennings, JD, MBA, EA, RFC®, CEP®, CES™, aka Tax King Matt to develop a tax-loss harvesting strategy tailored to your individual circumstances.
In summary, tax-loss harvesting is a tax-efficient investment strategy that involves selling underperforming investments to offset capital gains and potentially reduce taxes. By following the rules and implementing effective strategies, investors can optimize their tax situation while maintaining a well-diversified portfolio aligned with their long-term financial goals.