What Is Tax-Loss Harvesting?

Every time you earn money from your assets, such as stocks, bonds, or real estate, you’ll owe a portion to the Internal Revenue Service (IRS). It’s a necessary piece of investing and making money. There are, however, some strategies you can take to minimize tax losses.

One of the most common and effective is tax-loss harvesting. In short, this is a way you can reduce the amount you pay on capital gains by selling investments as a loss. The general idea is that the losses offset what you owe up to a certain threshold, thus mitigating your tax liability.

In this article, we’ll explore how this process works, including its benefits and downsides. We’ll also outline the important rules you’ll need to follow if you decide to implement loss harvesting, as well as how an advisor can help.

How Tax-Loss Harvesting Works

Tax-loss harvesting is an optimization method that allows you to offset taxes on capital gains. It works by selling your underperforming investments and replacing them with comparable assets. Then, you’ll be able to claim the losses you’ve incurred when you file your taxes, lowering the amount you need to pay.

Here’s a step-by-step look at how it works:

1. Identify losses. This is where you take a holistic overview of the assets in your portfolio. Specifically, the ones you would target for loss harvesting would be those that have decreased in value.
2. Sell losing positions. Once you’ve identified losing assets, the next step is to sell them. This makes the losses count as a potential offset to your taxes.
3. Buy similar (not identical) assets. After selling the assets, you’ll have to replace them with similar ones. They can’t be the exact same, though. This would violate the IRS’s “wash-sale” rule, which disallows buying too closely related investments.
4. Offset gains. As long as your capital gains fall below your losses for the present year, you can write off up to $3,000 of losses on your taxes. If you exceed this, however, you’re also able to carry the remaining losses forward to subsequent years, helping reduce your future losses.

What Is the Wash-Sale Rule?

The wash-sale rule, according to the U.S. Securities and Exchange Commission (SEC), prohibits buying “substantially identical securities,” including contracts and options, 30 days before or after selling another for a loss.

Violating the rule means that you won’t be able to use the sale of the losing security to offset your tax losses in the current year. So, if you plan on using tax-loss harvesting, it’s imperative to follow it to the letter. As we’ll talk about later in the article, this is something a financial advisor or tax planner often provides guidance on.

Tax-Loss Harvesting Benefits

Anything having to do with taxes and their optimization can seem complex. However, tax-loss harvesting is a straightforward strategy that, if done right, can prove to be very effective. Below is a breakdown of its primary benefits:

Reduces Tax Burden

This is the most prominent draw to harvesting. By essentially counteracting the taxes you’d be paying on the returns your investments produce, you minimize your overall federal tax liability. In other words, less of your money goes to the government and more of it stays in your pocket.

Stephen H. Akin, founder and investment advisor representative at Akin Investments, offered his insight on the tax benefits of the strategy, “For someone new to investing I would stress the fact that the IRS allows you to deduct up to $3,000.00 each year in investment losses that can reduce the amount of other income. That offset is the biggest benefit to tax loss harvesting.”

However, the offset in a specific year is only one component of the tax benefits investors can reap by harvesting. Akin highlights that “there is a carry forward allowance that is also permitted if the loss is greater than the $3,000.00 annual allowance.” He added that “[as] a money manager and financial planner,” he remains “amazed at how many people are unaware of this deduction.”

Portfolio Improvement

An additional upside to tax-loss harvesting is that it enables you the opportunity to rebalance your portfolio and get rid of losing investments. After selling, you’ll have the chance to replace them with new, potentially higher-performing assets.

Parting with losing assets isn’t always easy to do, however. Why is this the case? Robert R. Johnson, PhD, CFA, CAIA, and Professor of Finance at Creighton University, observes that “[there] is a big behavioral finance influence on tax loss harvesting.” He says, “Investors are so reluctant to suffer losses that they are sometimes willing to accept some unrewarded risk in an effort to avoid realizing them” and that “[many] hold onto losing positions, often telling themselves they will sell the holding once they break even.”

This loss-averse mindset, per Johnson, a former high-level executive at both the CFA Institute and The American College of Financial Services, “leads to what many [describe] as the disposition effect, which is the tendency of investors to sell winners and hold on to losers.” He notes that this “tends to encourage poor tax management strategy, as well. Selling losers and holding on to winners, all else equal, tend to accelerate our tax credits and defer our tax bills, which over time can do quite a bit to minimize tax drag. The disposition effect has the tendency to accelerate our tax bills and defer our tax credits, which is the opposite of what we should want.”

Risk Reduction

Another benefit of tax-loss harvesting is its ability to help you mitigate risk. This is primarily because it allows you to jettison potentially volatile assets. As mentioned in the previous benefit, you’ll be able to add different securities to your portfolio that better fit your strategy for diversification and asset allocation, along with the level of risk management you prefer.

How Can a Financial Advisor Help?

In the specific case of tax-loss harvesting, a financial advisor can help ensure you’re using the strategy effectively and within the bounds of the law. For example, they’ll often be able to sit down with you and review which investments would be ideal to sell at a loss and replace.

“Each year as fall rolls around I revisit the topic with my clients to make sure we have everything covered,” says Akin, owner of a registered investment advisor (RIA) firm. He outlines how he would help his clients with harvesting while still adhering to the IRS’s wash-sale rule, “The downside to selling at a loss especially in a company that you really like for the long term is that often after the new year begins the stock tends to stabilize and as new money finds its way in to the company stock it can rally to new highs.” Therefore, he continues, “if my clients take advantage of the strategy we will allow for the [wash-sale] rule that means you [cannot] repurchase the stock for 30 days.” After they’ve realized the loss and exited the wash-sale window, he says, “we can then go back into the company stock and it once again takes its long term place in our investment portfolio.”

This is just one example of how an advisory expert can lend their unique expertise to both help you play by the rules and maintain the trajectory of your portfolio and long-term financial plan. In Akin’s words, “As a fiduciary financial advisor I make sure that my clients and prospective clients understand the opportunities that are there and I help them take advantage of them.”

Frequently Asked Questions

What are the disadvantages of tax-loss harvesting?

One of the main drawbacks to the strategy is that you’ll have to face selling assets you own. And even though you’re doing so while they’re underperforming, there’s always a chance of losing out if they rebound. While you could always purchase them again after the 30-day wash-sale period ends, there’s no guarantee they’ll be worth the same as they were before. This could cause even more losses, in both opportunity and dollars, than you bargained for.

Is loss harvesting a good strategy?

This depends on your goals and financial situation. It can allow you to lower your tax liability, put your portfolio back on track, and manage risk, among other benefits; however, it also means you need to research and select new securities. To better understand the strategy and whether it’s right for you, we recommend talking to a financial advisor.

What is the tax-loss harvesting limit per year?

According to the IRS, you can use $3,000 ($1,500 for married couples who file separately) to offset your income (i.e., salary, dividend, etc.) if your capital gains fall below your losses. If you exceed this limit, the IRS allows you to carry the rest over to other years.