The 10 Rules of Tax-Loss Harvesting
If you have a few investments going south this year, those underachievers could be your ticket to a lower tax bill.
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What is tax-loss harvesting?
Tax-loss harvesting is a tax strategy that involves selling certain investments at a loss in order to offset capital gains taxes on other investments.
Basically, you “harvest” investments to sell at a loss, then use that loss to lower or even eliminate the taxes you have to pay on gains you made during the year. But there are some rules you must remember in order to do tax-loss harvesting correctly.
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Important tax-loss harvesting rules
1. It’s best for investments held in taxable accounts
The idea behind tax-loss harvesting is to offset taxable investment gains. Because the IRS usually does not apply capital gains tax to investments in tax-sheltered accounts — such as 401(k)s, 403(b)s, IRAs and 529s — there’s usually no reason to try to minimize your capital gains on the investments in those accounts.
2. It’s not as financially fruitful if you’re in a low tax bracket
Since the idea behind tax-loss harvesting is to lower your tax bill, it's most beneficial for people who are currently in high tax brackets. If you’re currently in a low tax bracket and expect to be in a higher tax bracket in the future (via well-deserved promotions at work, vesting restricted stock units or if you think Uncle Sam will raise tax rates), you might want to save the tax harvesting until you’re in a higher tax bracket so you’ll reap more savings from the strategy.
3. You have to have a record of your cost basis
A capital gain (or loss) is the difference between what you paid for the investment (your cost basis) and what you later sold it for. Unless you purchased your entire position at a single time, the price you paid for a particular position or investment probably varies. Good records of every purchase are required to report the proper capital gain or loss to the IRS. A good financial advisor can help you decipher your trading records to figure this out.
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4. If you're going for it, you only have until Dec. 31
Procrastinators take note: Some investing work — such as opening and funding an IRA — can be done up until the tax filing deadline of the following year. However, there is no such grace period for tax-loss harvesting. You need to complete all of your harvesting before the end of the calendar year.
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5. Tax-loss harvesting is most useful if you’re investing in individual stocks, actively managed funds and/or exchange-traded funds
Index fund investors typically find it difficult to employ tax-loss harvesting in their portfolios. However, if you’re indexing using exchange-traded funds or mutual funds that focus on a particular niche (a sector, geographic area or market cap, for example), it’s a different story. That’s where using a financial advisor or robo-advisor comes in handy. Good ones watch for and alert you to opportunities to minimize taxes and offset gains.
6. You must keep your apples and oranges straight
Capital gains taxes are based in part on how long you owned the investment.
Long-term capital gains tax rates apply to investments held longer than a year. The IRS rewards you for your patience by taxing your gains at 0%, 15% or 20% (or less if you fall into the lower tax brackets). Long-term capital gains tax rates are generally lower than short-term capital gains tax rates.
Short-term capital gains tax rates apply to investments held for a year or less. Short-term capital gains are taxed as ordinary income, much like wages.
There’s another important reason to pay attention to the distinction: The IRS checks your homework when you file Schedule D to report your capital gains and losses.
7. Don’t sell your losers just to get the tax break
Don't become overzealous as you look through your portfolio for investments to harvest for tax losses. Unless there’s something fundamentally wrong with the investment that has caused it to lose value, you’re usually better off holding on and letting time and the magic of compound interest smooth out your returns.
8. Put the cash from the sale to good use
If you do decide to sell, deploy the proceeds thoughtfully. For example, perhaps you could use them to rebalance your portfolio if your asset allocation has gotten out of whack, or you could consider investing in a company on your watch list, buying an ETF or mutual fund that gives you exposure to a sector or asset class that you currently lack, or adding to an existing position you believe still has great potential. A financial advisor can help you decide.
9. Don’t put the proceeds back into the exact same investment
Be mindful of violating the wash sale rule, which prohibits you from deducting your loss if, within 30 days of selling the investment (either before or after), you or your spouse invest in something identical (the same stock or fund) or, in the IRS’ words, “substantially identical” to the one you sold. Accordingly, you should consider whether you'd be okay missing out on the next 30 days of potential returns after selling. See a financial advisor to decide how to manage this.
» Wondering how to keep your tax burden in check? More strategies for reducing capital gains.
10. You may be able to apply some of this year's losses to future tax years
If you had a particularly brutal year and racked up more capital losses than capital gains, don’t fret: you may still be able to use the losses to offset the taxes you pay on your ordinary income, too. That's because if an investor's total capital losses exceed their total capital gains for the tax year, they may be able to write off up to $3,000 ($1,500 if married filing separately) of those losses from their ordinary income. Anything over that $3,000 limit can be carried over and deducted in future years until you’ve used up the entire amount.
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