What Is Tax-Loss Harvesting?
Tax-loss harvesting is a means for investors to take advantage of capital losses on their investments to offset gains on other investments, thereby reducing or eliminating capital gains taxes. Investors "harvest" their losses by selling some securities at a loss and others at a gain.
Understanding what tax-loss harvesting involves and the rules of taxation can help you put the strategy into practice successfully.
Basics of Capital Gains and Losses
A capital gain occurs when you sell a security like a mutual fund or ETF at a higher price than its purchase price; you incur a capital loss if you sell a security for a lower price than you bought it. But you don't truly realize the gain or a loss on any security as a taxable event until you sell it. Until then, you just have an unrealized gain or loss—or an increase or decrease in investment value on paper (or online)—based on the security's current worth.
Impact of Tax-Loss Harvesting on Your Taxes
Understanding the tax consequences of selling securities like mutual funds is essential for successful investing. When you have a capital gain, you'll owe capital gains tax. Long-term capital gains, which apply to securities held for over one year, are taxed at lower rates; a maximum tax rate of 20% applies, but most taxpayers will pay zero in taxes or a 15% rate. In contrast, short-term capital gains, which you incur if you sell a security you hold for one year or less, are taxed at higher ordinary income tax rates.
Even so, you'll only pay these taxes on "net gains," or gains minus losses. If your gains exceed your losses, you can use a capital loss to offset a capital gain. If your losses exceed your gains during the tax year, you can reduce your taxable income by the lesser of $3,000 or your total net losses. If net losses exceed $3,000, an investor can carry forward any unused losses into future tax years. This strategy of using capital losses to offset capital gains or reduce regular income is known as '"tax-loss harvesting."
Tax harvesting can be valuable to an individual who invests in taxable brokerage accounts, either as a means of reducing or eliminating capital gains or reducing ordinary income. But the strategy isn't appropriate for tax-deferred accounts like 401(k) or IRA accounts since the original investment and earnings already grow tax-free in these accounts.
If you're married filing separately, you can only reduce your taxable income by up to $1,500 in losses.
Tax-Loss Harvesting Examples
The key to using this strategy is to pay attention to the fair value of one share of the security, also known as the Net Asset Value (NAV).
For example, suppose you invested $1,000 in Fund A and $1,000 in Fund B. Two years later, Fund A is worth $1,500 and Fund B is worth $500. If you sell both funds today, you will realize a $500 capital gain on Fund A and a $500 capital loss on Fund B. The gain and loss would offset each other, so you would not owe any tax.
Now, let's say that you invested $6,000 each in Fund A and Fund B, but five years later, Fund A is worth $7,000 and Fund B is worth $2,000. You will have a capital gain of $1,000 and a loss of $4,000, resulting in a net loss of $3,000. In this case, you would not owe any tax on the gain, and you could reduce your taxable income by $3,000.
Tips for Tax-Loss Harvesting
If you proceed with this strategy, enlist best practices to minimize your tax liability.
Be aware of the "wash-sale" rule. Some investors like to buy back at a later date the same fund that they earlier harvested (sold). But the IRS rule surrounding wash sales stipulates that if you sell a security at a loss, and then buy a "substantially identical" security within 30 days (before or after) of the sale, you can't deduct the loss unless you incurred it in the course of doing ordinary business.
Don't confuse tax-loss harvesting with capital gain distributions. Capital gain distributions are distributions that a mutual fund pays from its net realized long-term capital gains. You can use losses to offset these capital gains distributions, but you can't use losses to offset distributions of net realized short-term capital gains, which are treated as ordinary dividends rather than capital gains.
Understand asset location. A wise investor can also reduce taxes in a regular brokerage account by reducing income from dividend-paying mutual funds and taxes from capital gains distributions through a strategy called asset location. This is when you place tax-efficient investments that generate little to no income within taxable accounts.
It's a year-round activity. Tax-loss harvesting is often a year-end investment strategy, but a savvy investor should be mindful of all fund purchases and sales throughout the year and make investment decisions based upon financial objectives, not market whims.
Vanguard. "Offsetting Gains Through Tax-Loss Harvesting." Accessed April 7, 2020.
Internal Revenue Service. "Topic No. 409 Capital Gains and Losses." Accessed April 7, 2020.
TD Ameritrade. "Tax-Loss Harvesting." Accessed April 7, 2020.
Fidelity. "Understanding an ETF's NAV." Accessed April 7, 2020.
Charles Schwab. "Reap the Benefits of Tax-Loss Harvesting to Lower Your Tax Bill." Accessed April 7, 2020.
Internal Revenue Service. "Publication 550 (2018), Investment Income and Expenses." Accessed April 7, 2020.
Fidelity. "How to Cut Investment Taxes." Accessed April 7, 2020.
Internal Revenue Service. "2019 Instructions for Schedule D," Page 2. Accessed April 7, 2020.
Vanguard. "IRA Insights: Location, Location, Location," Page 1. Accessed April 7, 2020.