Tax loss harvesting is a tax strategy to minimize any taxes on capital gains. It is applicable to taxable accounts.
Basically, if you sell a stock for a gain, you would then sell another stock that has lost value so that losses offset the gains.
What is Tax Loss Harvesting?
Imagine reviewing your portfolio and realizing that your technology stocks have risen sharply while some of your industrial stocks have lost value. So you have now exposed too much of the value of your portfolio to the technology sector. To realign your investments with your preferred allocation, sell some technology stocks and use those funds to rebalance. In the process, you end up recognizing a significant taxable gain.
This is where tax-loss harvesting comes in.
If you also sell industrial stocks that have lost value, you could use those losses to offset the capital gains from the sale of technology stocks, thus reducing your tax liability.
If your losses outweigh the gains, you can use the remaining losses to offset up to $3,000 of your ordinary taxable income (for couples filing separately, the limit is $1,500). Any remaining losses may be carried forward to future tax years and used to offset future income.
How does tax loss harvesting work
Let’s say your gain equaled your loss.
You invest $1,000 in Apple and Microsoft. Apple is now worth $1,500 and Microsoft is worth $500. If you sell, you will realize a $500 capital gain on Apple and a $500 capital loss on Microsoft. But the gain and loss would offset each other, so you wouldn’t owe any tax.
Let’s say your gain is greater than your loss.
Here’s how that would work.
You invest $6,000 in Apple and Microsoft. Apple is now worth $7,000 and Microsoft is worth $2,000. If you sell, you will have a capital gain of $1,000 and a loss of $4,000, resulting in a net loss of $3,000. You wouldn’t owe any tax on the gain, and you could reduce your taxable income by that $3,000.
Here’s another more visual example of tax savings.
What to consider before tax loss harvesting?
As with any tax related topic, there are rules and restrictions, including:
- Harvesting tax losses does not make sense in retirement accounts such as 401 (k) or IRA, because losses incurred in a tax-deferred account cannot be deducted.
- There are limits on the use of certain types of losses to offset certain profits.
- A long-term loss would be applied first to a long-term gain.
- A short-term loss would be applied to short-term gain. If there is excessive loss in a category, it can be applied to any type of gain.
- The wash-sale rule, which states if you sell a security at a loss and buy the same or a “substantially identical” security within 30 days before or after the sale, the loss is typically disallowed for current income tax purposes.
4 Key Takeaways
- When harvesting tax losses, capital gains are offset against capital losses, so that little or no capital gains tax is due.
- Investors intentionally sell some securities at a loss to achieve this when they have significant gains.
- Losses can offset regular income by up to $3,000 if they exceed gains.
- Any losses over that $3,000 threshold can be carried forward into future tax years.