How to Harvest Losses or Gains Each Year to Save on Taxes

A guide to managing capital gains for mutual fund investors

Man holding harvest of grapes representing gains and losses.
The same way you harvest crops, you can harvest gains and losses in a way that reduces your tax bill. Blend Images - Sollina Images/Getty Images

If you are an investor who owns stocks or mutual funds in non-retirement accounts, you can benefit from realizing capital gains or harvesting losses each year. To manage capital gains you look for years where it makes sense to intentionally “harvest” gains or losses depending on your projected tax bracket for that year.

Managing capital gains and losses can reduce the amount of cumulative taxes you pay, increase your after-tax returns, and in many cases allow you to realize tax-free gains.

To manage capital gains you have to know how capital gains taxes work and you have to estimate your taxable income each year.

Capital Gains Taxes

There are both short-term and long-term capital gains. Long-term capital gains occur if you sell an investment for more than you paid for it and you’ve owned the investment for at least one year. 

Long-term capital gains and qualified dividends are taxed at a lower tax rate than other types of income such as earned income or interest income. For those in the 15% or lower tax bracket, long-term gains have a zero percent tax rate.

Capital losses occur when you sell an investment for less than you paid for it. On your tax return, first capital losses are used to offset any short-term gains, then they offset any long-term gains. If you have more losses than gains, then up to $3,000 of a loss can be used to offset ordinary income, and the rest carries forward indefinitely to be used in future years.

Using the Rules

Once you know the rules, you can use them to legally pay less in taxes. Here are three basic guidelines to follow:

  1. In years where you will be in the 15% or lower tax bracket, and when you have no capital loss carry forward, you will want to intentionally realize enough long-term capital gains to fill up your income to the top of the 15% bracket. This is called “harvesting” capital gains.
  1. In years where your income is high and you have no capital loss carry forward and no realized gains, then intentionally sell investments that may be down in value so you can realize the capital loss for tax reasons.
  2. If you have capital losses that are being carried forward, you may want to avoid realizing gains, and let those capital losses be used to gradually offset ordinary income. This means you will need to choose tax efficient investments in your non-retirement accounts. Your best choices will be tax managed funds or index funds.

In order to use these rules you will need to know the current tax rates, and you will need to do a tax projection each year before the end of the year. A tax projection is a projected tax return; it contains an estimate of everything you think will show up on your tax return.

By using an investment approach that consistently pays attention to taxes you can keep more of what you earn and thus increase your after-tax retirement income. One possible way to do this is to rearrange investments in such a way that you own more interest income producing investments inside your retirement accounts (like bonds and bond funds) and more capital gains producing investments inside non-retirement accounts (like stocks and stock-index funds).