What is Tax Loss Harvesting?

In the eternal quest to achieve portfolio optimization, tax loss harvesting has become a popular concept among investors these days. But what exactly is tax loss harvesting? And is it a sound strategy for your portfolio—or just another industry buzzword?

Below, we’ll break down this concept, explore how it works, and reveal why it can actually be a valuable year-round tactic in your wealth management strategy.

Tax Loss Harvesting, Defined

Tax loss harvesting is a strategy used to reduce taxable income by selling investments at a loss and using those losses to offset capital gains or other income.

When you hold a diversified portfolio, it’s not uncommon for some investments to experience gains while others may decrease in value. Instead of simply letting those losses sit idle, tax loss harvesting proactively puts those losses to work.

Tax loss harvesting typically involves three steps:

1. Identifying securities in your portfolio that have dropped below their purchase price.
2. Selling those securities to realize the capital loss.
3. Reinvesting the proceeds into a similar (but not substantially identical) asset to maintain your overall investment strategy.

By selling underperforming securities and strategically reinvesting, you can effectively manage your tax liability while staying aligned with your long-term investment goals.

How Does Tax Loss Harvesting Work? 

To understand how tax loss harvesting works, it’s helpful to know a bit about the U.S. tax treatment of capital gains and losses. Investments typically generate two types of returns:

• Capital gains occur when the value of an investment increases and you sell the asset for more than its purchase price. These gains are taxable.
• Capital losses occur when you sell an investment for less than its purchase price. These losses can be used to offset gains.

Through tax loss harvesting, the losses from your underperforming investments can be used to offset realized gains from other investments. For example, if you made $50,000 in capital gains from one investment but realized a $30,000 loss from another, the net taxable gain would be reduced to $20,000.

If your losses exceed your gains, you can use up to $3,000 of those losses to offset other taxable income, such as wages or interest. If losses exceed this limit, the remaining losses can be carried forward into future tax years. There is no limit to the number of years you can carry over a capital loss.

The Ground Rules for Tax Loss Harvesting

There are three essential ground rules to consider when deciding if and when tax loss harvesting is right for you.

• Non-Qualified Accounts Only: Tax loss harvesting can only be applied to non-qualified investment accounts, namely your brokerage accounts. Non-qualified accounts are those that do not qualify for special tax advantages. Qualified accounts, such as 401(k)s, traditional IRAs, Roth IRAs, and 403(b)s already qualify for certain tax advantages and are therefore ineligible for tax loss harvesting.

• Short-Term versus Long-Term Holdings: Any security you’ve held for less than a year is considered a short-term investment, and the gains (if there are any) will be taxed at a higher rate than those of a long-term investment. As such, the IRS dictates that short-term gains can only be offset by short-term losses, and long-term gains can only be offset by long-term losses. So, you will have to match your assets carefully as you’re deciding what to harvest.

• The Wash-Sale Rule: The IRS’s wash-sale rule prohibits you from selling a security at a loss and immediately purchasing a “substantially identical” asset within 30 days before or after the sale. Violating this rule will disqualify the tax benefit associated with the realized loss.

To avoid triggering the wash-sale rule, you may consider reinvesting in a different but related security, such as an exchange-traded fund (ETF) or a mutual fund that tracks the same sector or market. Alternatively, you can wait for 31 days and repurchase the original security.

Interestingly enough, the wash-sale rule does not apply to securities you sell at a gain. There may be times when it strategically makes sense to sell a high-performing investment so that you can recognize the gain on your ledger now, and then turn around and buy that same security back immediately after the sale. Under current tax law, that’s entirely permissible.

4 Reasons Why Tax Loss Harvesting May Be Right For You

As you’ve probably realized by now, tax loss harvesting offers several opportunities for you as an investor, particularly if you have a sizable, well-diversified portfolio. These include:

1. Reducing Your Tax Liability: The obvious reason for engaging in tax loss harvesting is to potentially reduce your tax bill. By using losses to offset gains, you can significantly lower the amount of taxes you owe on investment earnings. For high-income earners in top tax brackets, this can result in substantial tax savings.

2. Enhancing After-Tax Returns: Minimizing taxes may improve your portfolio’s overall after-tax return. Keeping more of your investment gains could help maximize the compounding effect of your wealth, helping your money continue to grow more efficiently over time.

3. Long-Term Tax Benefits: As mentioned above, tax loss harvesting gives you the ability to carry forward unused losses to future tax years. This means that even if your taxable income increases in subsequent years, those carried-over losses can help mitigate the impact on your taxable bottom line.

4. Another Opportunity for Portfolio Rebalancing: Look at tax loss harvesting as another tool you can add to your portfolio rebalancing toolkit. By selling underperforming assets you can redirect funds into other areas that better align with your investment objectives or take advantage of emerging market opportunities.

Timing & Tax Loss Harvesting

Tax loss harvesting is often conducted toward the end of the calendar year, as investors assess their gains and losses for the year. However, opportunities to strategically harvest your losses can present themselves at any time, particularly during volatile market conditions. Working with a financial advisor who monitors your portfolio regularly can help you identify these opportunities year-round so that you don’t miss out.

What if I Don’t Have Any Losses to Harvest?

Yes, occasionally there may be some wonderful periods in your investment history when you don’t have any real losses to offset your gains. In those instances, tax loss harvesting is off the table—but that doesn’t mean you’re out of options.

One popular solution is to donate an investment to charity. By doing so, you can remove a high-performing asset from your portfolio without incurring capital gains taxes. Additionally, you may be eligible for a charitable deduction, further boosting your tax efficiency. What’s more, it’s a great way to align your financial objectives with your philanthropic intentions. Read our guide on to learn more.

Another option is to gift the asset to another person. Different tax brackets have different capital gains tax rates—so if the gift recipient is in a lower tax bracket, they can retain even more of the asset’s gains when they go to sell it. This can often be a smart alternative to gifting cash.

Don’t Attempt Tax Loss Harvesting Alone!

As you’ve probably surmised, tax loss harvesting is complex, with a lot of rules and moving parts. What’s more, it’s easy to fall into an asset-by-asset fixation and lose sight of your big investment picture. The “tax savings” tail can easily start wagging the “investment strategy” dog.

Given these concerns, tax loss harvesting is best handled as part of your overall wealth management strategy under the oversight of a financial planner. A skilled advisor can help you:

• Identify assets that are eligible for tax loss harvesting.
• Navigate the intricacies of the tax loss harvesting rules to avoid penalties.
• Monitor your portfolio throughout the year for harvesting opportunities.
• Coordinate your tax loss harvesting with your CPA to ensure all your details are buttoned up when it’s time to file.
• Balance your tax loss harvesting tactics with your overall investment allocation strategy to help ensure your long-term wealth management goals aren’t compromised by short-term distractions.

If you’d like to learn more about tax-loss harvesting, request an educational call with our CERTIFIED FINANCIAL PLANNER ® professionals now.

And be sure to check out more of our advice on smart tax strategies in our Education Center, including our Top Tax Strategies for Your Long-Term Success and our starter guide on How to Build a High Net Worth Tax Strategy

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NOTICE: This explanation is provided for informational purposes only and is not to be construed as or considered to be legal or tax advice. You should always consult your tax advisor with any and all questions regarding any all tax and tax related matters, including any questions that you may have concerning tax strategies described generally above.

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