Tax Loss Harvesting: What Is It & How to Use It to Reduce You Tax Bill

Wash-Sale Rule

The wash-sale rule dictates that the investor is required to avoid buying the same security that was just sold at a loss for tax-saving purposes. This involves the sale of one security and the purchase of that same security within 30 days of its sale. If the transaction is considered a wash-sale by the IRS, then it cannot be used to offset capital gains tax. This means that investors must not abuse this rule, as IRS regulators can potentially impose strict fines and restrict an investor’s ability to trade certain securities. To not violate any regulations, make sure to follow the following rules to avoid incriminating situations involving short-term gains tax.

1. Tax-Loss Harvesting Only Applies to Investments Held in Taxable Accounts

The concept of tax-loss harvesting is to help offset short-term taxable investment gains. Because the IRS does not tax growth on investments in tax-sheltered accounts such as IRAs, 529s, 401ks, and 403bs, it is important not to apply tax loss harvesting rules on those accounts to remain compliant with the IRS. As long as one’s funds remain within the tax-sheltered account, one’s investments can generate returns without the IRS taxing the funds.

2. Tax-Loss Harvesting Does Not Work as Well for Individuals in Lower Tax Brackets

The idea behind tax-loss harvesting is to help lower one’s tax bill. This means that this rule is most beneficial to those in higher tax brackets as they are typically able to invest more. It can also be said that the higher one’s income tax bracket is, the bigger the savings. For those in lower tax brackets but expect to be in higher tax brackets in the future through promotions or inheritance, it would be best to save tax harvesting strategies to another date when one would be ready to reap the most benefits from this strategy.

3. Tax-Loss Harvesting Is Most Useful for Investing in Individual Stocks, Exchange-Traded Funds, or Actively Managed Funds

Investors who typically invest in index funds often have a difficult time implementing tax-loss harvesting into their portfolio strategy. However, for investors who are indexing exchanged-traded funds, known as ETFs, or mutual funds focusing on a particular niche, that can be a different story, as tax-harvesting works very well for those investments.

4. Understand the Specifics of Tax-Loss Harvesting

The taxes an investor pays on their investment gains are determined by the length of time that investment was bought or held. According to IRS holding-period rules, long-term capital gains tax rates are applied when an investor sells an investment that was held for longer than a year. The IRS rewards this type of financial patience by taxing investors 0%, 15%, or 20% on their gains, depending on their tax bracket. Meanwhile, short-term capital gains tax kicks in when investors sell a security that they have held for a year or less. This gain is taxed as ordinary income, much like one’s wages which often end up having higher tax rates than long-term capital gains tax. The IRS checks one’s investment gains when one files a Schedule D to report their capital gains and losses, so it is important to understand the difference and especially its impact on the amount of taxes that will need to be paid to the IRS.

5. Don’t Sell Losses Just to Receive the Tax Break

One should remember not to become overzealous when exploring tax-loss harvesting options for one’s portfolio. The purpose of investing in securities is to achieve long-term growth that beats the returns of other assets such as bonds, CDs, money market funds, and savings accounts. In exchange for higher returns, investors have to bear the brunt of risk exposure and short-term volatility. Unless there is something fundamentally wrong with the investment that needs to be sold as it has lost its significant value over the course of a year, it is better to hold on to the security and let the magic of time and compound interest smooth out the returns over the future.

6. Put the Cash to Good Use From the Sale

Just as there are immediate benefits of tax-loss harvesting, such as the decrease in capital gains tax, the medium to long-term payoffs are equally as great. Investors who sell securities for a loss now can reinvest their finances into something more attractive or secure depending on any changes in investment strategy. Now that some money has been freed up, one can deploy their finances thoughtfully by using them to rebalance their portfolio if the asset allocation has been altered, invest in a company on one’s watch list, and buy into a mutual fund or ETF that was in one’s radar giving an investor the exposure they are looking for in that asset class or sector that is currently lacking.

That being said, if an investor has a particularly brutal investment year with more total losses than gains, don’t fret: Investors who do not have investment gains to minimize their capital gains tax can still use their losses to offset the taxes paid on their ordinary income and wages. If an investor’s capital loss exceeds more than their total capital gains tax for that year, then they may be eligible to write off up to $3,000 and $1,500 if married but filing separately. If the loss exceeds $3,000, then the remaining amount can be carried over and deducted on tax returns in future years until the entire amount is used up.