Here’s how tax-loss harvesting can work year-round for you

Most people are unhappy when their investments decrease in value. But there may be a silver lining to keep in mind: Investment losses can potentially become tax benefits through a process called tax-loss harvesting.

While many investors focus on tax-loss harvesting toward year end, it’s a strategy that can help you year-round. That’s particularly true during times of market volatility.

Tax loss harvesting is a tax-efficient investing strategy that can help minimize the amount of current taxes you have to pay on your investments. Under current US federal tax law, you can offset your capital gains with capital losses incurred during that tax year or carried over from a prior tax return. Capital gains are generally the profits you realize when you sell an investment for more than you paid for it, and capital losses are generally the losses you realize when you sell an investment for less than you paid for it.

Since US investors are taxed on net capital gains, offsetting capital gains with capital losses can lower your taxable income (provided you’re a US taxpayer). Let’s say that you hypothetically earn a profit of $30,000 by selling Fund A. Meanwhile, you notice that Fund B is down by $15,000. By selling Fund B, you can potentially use those capital losses to partially offset your capital gains from Fund A—meaning you’d possibly only owe taxes on $15,000 of profit instead of $30,000.

“Harvesting” that $15,000 loss, in this case, would have no effect on the portfolio’s value, and you could use the proceeds to buy a similar investment, subject to the "wash sale” rules. That would allow you to maintain roughly the same asset allocation while possibly reducing your federal income taxes, leaving you with additional funds that would remain in your investment account continuing to earn investment gains.

Your losses can also offset up to $3,000 of ordinary income each taxable year. Let’s use another hypothetical scenario. Say you realized a profit of $30,000 from Fund A. But in this scenario, Fund B lost $33,000. Assuming you had no other capital gains or losses for the year, you could use the loss to offset your entire gain from Security A, plus you could offset $3,000 of your ordinary income, further reducing your current income tax liability, or possibly increasing your tax refund.

You’ll want to make sure you don’t inadvertently participate in a “wash sale,” which occurs when you sell or trade stock or securities at a loss and buy the same or substantially identical stock or securities within 30 days before or after the sale. Basically, it says that you can’t sell Security B and then immediately buy it back again just to get the tax benefit, and if you do so, the capital loss will be deferred. You may, however, be allowed to claim the loss currently if you sell one stock and buy another one in the same industry—just not stock in the same exact company as before, or another investment the IRS would consider “substantially identical” to the one you sold.

The government incentivizes people to invest for the long-term rather than constantly buying and selling on ephemeral news. It does so by taxing short-term capital gains at a higher rate than long-term capital gains (profits from investments held longer than a year). So, it can have a particularly high impact on your tax bill to offset short-term investment gains with losses. Under current tax law, you’ll owe the tax rate on long-term capital gains (the maximum rate is 20%), while short-term capital gains get taxed at your regular income tax rate.

So, tax-loss harvesting can make a bigger difference if you trade a lot or have invested in strategies that see higher turnover and thus more short-term gains. Note that there are certain rules in the Internal Revenue Code that dictate whether particular capital losses offset short- versus long-term capital gains.

Of course, there’s no guarantee that tax-loss harvesting will achieve any particular tax result, or that it’s necessarily the best thing for you. Before implementing any tax strategy, check with your accountant or other US tax advisor.

The source of this article, “Tax-Loss Harvesting Can Work Year-Round for Investors—Here’s How,” was originally published on July 19, 2023.

CRC #3775841 09/2024