Updated on Wednesday, November 25, 2020
Tax-loss harvesting can help investors maintain a tax-efficient portfolio by using capital losses to offset capital gains. This strategy is designed to take some of the sting out of selling securities â€” whether it be stocks, mutual funds, exchange-traded funds (ETFs) or other investments â€” for less than what you paid for them.
While it wonâ€™t work with tax-advantaged accounts, such as a 401(k) or IRA, losses can be harvested for securities held in a taxable investment account. In this article, we cover how exactly tax-loss-harvesting works and what rules and limitations you should be aware of.
Tax-loss harvesting allows an investor to sell losing investments to offset capital gains and prevent paying taxes on those gains.
A capital gain is the profit you receive from selling an investment for more than what you paid for it. A capital loss is the opposite; you realize capital losses when selling investments for a lower price than for what you purchased them.
Capital gains are taxable, while capital losses can be tax-deductible. Both capital gains and capital losses can be categorized as short- or long-term, depending on how long you held the investment before the sale. Typically, if you hold a security for a year or less before you sell it, your capital gain or loss is short-term.
Tax-loss harvesting balances capital losses against capital gains. Implementing a tax-loss harvesting strategy means understanding:
The mechanics of tax-loss harvesting are relatively simple. First, review performance for each security you own in a taxable account. Once you identify the winners and losers, you can then decide which ones you want to sell. Tax losses are harvested as you sell investments for a capital loss or gain.
Hereâ€™s a more detailed example of how to tax loss harvest inside a taxable account: Letâ€™s say you purchased 100 shares of XYZ companyâ€™s stock at $20 per share for a total investment of $2,000. Those shares then drop in value to $10 per share, reducing their collective value to $1,000. If you sell them at that price, youâ€™d realize a capital loss of $1,000.
Now assume that you purchased 100 shares of a different company, at $20 per share. Those shares increase in value to $30 each, resulting in a $1,000 capital gain on your investment when itâ€™s time to sell. Using tax-loss harvesting, you could use the $1,000 capital loss from Investment A to cancel out the $1,000 capital gain from Investment B.
Tax-loss harvesting can yield tax benefits if youâ€™re focused on minimizing capital gains tax liability. For example, research from robo-advisor Wealthfront found that new clients who used their tax-loss harvesting service in 2018 would have easily received pre-tax benefits that exceeded the marketâ€™s declines for that year.
There are, however, some potential downsides. First, harvesting losses may be less effective for investors with fewer investable assets. A Vanguard study found that tax-loss harvesting benefits can range from zero tax benefit to a negative return to gains of more than 1% annually. But according to the research, those most likely to benefit were in the top 2% of net worth distribution.
Offsetting capital gains should also be balanced against the costs involved. If youâ€™re paying commissions to a brokerage each time you buy or sell investments to harvest losses, that could add up to more money than youâ€™d save in taxes.
According to the IRS, a wash sale is â€śa sale of stock or securities at a loss within 30 days before or after you buy or acquire in a fully taxable trade, or acquire a contract or option to buy, substantially identical stock or securities.â€ť
A simpler way to define a wash sale is buying securities that are very similar to ones you sold for tax-loss harvesting purposes within a 30-day window. That window applies to the 30 days before and after a trade occurs.
The key reason to avoid a wash sale is because the IRS doesnâ€™t allow you to reap the benefits of tax-loss harvesting on those transactions. Essentially, this rule is designed to prevent investors from getting a tax deduction on capital losses for which they immediately buy back an identical or nearly identical investment. Here are some examples of when the wash sale rule does and doesnâ€™t apply:
Tax-loss harvesting can offer tax benefits, but there are limitations on what you can deduct. Currently, the amount of excess losses you can claim as a deduction is the lesser of $3,000 ($1,500 if youâ€™re married and file separately) or the total net loss that appears on line 21 of Schedule D on your tax return.
The good news is that, if your total losses exceed the deduction limit, you can carry the difference over to future tax years.
Tax-loss harvesting is something you can do on your own. It can be complicated, though, and there are several items to keep in mind â€” most significantly the wash sale rule and deduction limits. If you need help with tax-loss harvesting, you have some options.
Financial advisors can offer tax-loss harvesting to clients. Whether this is done automatically or at the request of individual investors can vary, depending on the firmâ€™s policy and advisory strategy.
If a financial advisor is harvesting losses for you, they may complete a thorough review of your portfolio to assess how well or poorly each of your investments has performed. The advantage of using a human advisor to harvest losses is that they can also take a holistic view of your financial picture to determine the most efficient way to manage tax liability.
Whether a financial advisor offers tax-loss harvesting and how they approach it may be spelled out in their client brochure. Itâ€™s not uncommon for financial advisors that offer tax-loss harvesting to use proprietary strategies to harvest losses, based on clientsâ€™ assets, goals and objectives.
Robo-advisors can also offer tax-loss harvesting and, typically, this is done automatically. Similar to how robo-advisors use an algorithm to determine your ideal asset allocation and investment strategy, they can also apply an algorithm model to harvest losses.
For example, Betterment offers tax-loss harvesting through an automated algorithm that regularly checks your portfolio for harvesting opportunities. Wealthfrontâ€™s tax-loss harvesting offering is available with all investment accounts, and you can get individual stock-level harvesting once your account balance or total net deposits reach $100,000. On the other hand, tax-loss harvesting with Vanguard Personal Advisor Services isnâ€™t automatic and instead is done on a client-by-client basis.
Be sure to consider how well automated tax-loss harvesting with a robo-advisor works for your overall investment strategy. Before agreeing to automatic tax-loss harvesting, consider how it may affect your tax liability for other taxable investment accounts you own elsewhere.
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