How to Use Tax-Loss Harvesting in Your Investment Strategy
Tax-loss harvesting is a powerful yet often underutilized strategy that can help investors reduce their tax liabilities while maintaining their long-term investment goals. By strategically selling underperforming investments, you can offset gains, minimize taxes, and even improve your portfolio’s overall efficiency.
In my experience, tax-loss harvesting is one of the most effective ways to optimize returns without taking on additional risk. However, it requires careful planning to ensure compliance with IRS rules and alignment with your financial objectives.
By the end of this article, you’ll understand:
• What tax-loss harvesting is and how it works.
• The rules you need to follow to avoid pitfalls like the wash-sale rule.
• Practical steps to incorporate tax-loss harvesting into your investment strategy.
Why Listen to Me?
As a CERTIFIED FINANCIAL PLANNER™ professional, I’ve guided clients through the complexities of tax-loss harvesting for years. Investors I’ve worked with often express relief when they see how this strategy can turn market downturns into opportunities for tax savings.
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Key Takeaways
• Tax-loss harvesting involves selling investments at a loss to offset taxable gains or reduce your taxable income.
• The strategy works best in taxable accounts, as tax-advantaged accounts like IRAs and 401(k)s don’t benefit.
• Avoid the wash-sale rule by waiting at least 30 days before repurchasing the same or a substantially identical investment.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is the process of selling investments that have declined in value to offset capital gains from other investments or reduce taxable income.
Example:
• You sell a stock with a $5,000 gain.
• You also sell another stock with a $3,000 loss.
• Your net taxable gain is reduced to $2,000, lowering your tax liability.
Short-Term vs. Long-Term Gains
Tax-loss harvesting applies to both short-term and long-term capital gains, but the benefits differ:
• Short-Term Losses: Offset gains taxed at higher ordinary income rates.
• Long-Term Losses: Offset gains taxed at lower capital gains rates.
If losses exceed gains, you can use up to $3,000 per year to reduce ordinary income and carry forward any remaining losses to future years.
Rules to Know
The Wash-Sale Rule
In my experience, the wash-sale rule is the most common pitfall for investors attempting tax-loss harvesting. This rule prohibits you from repurchasing the same or a “substantially identical” investment within 30 days before or after the sale.
How to Avoid It:
• Replace the sold investment with a similar but not identical asset. For example, sell one S&P 500 index fund and buy another fund that tracks a similar but not identical index.
Limits on Deductions
• You can offset gains with losses dollar-for-dollar.
• If your losses exceed your gains, you can deduct up to $3,000 against your ordinary income.
When Should You Use Tax-Loss Harvesting?
1. At Year-End
- Tax-loss harvesting is often most effective at year-end when you have a clear picture of your total capital gains and losses for the year.
2. During Market Downturns
- In my experience, market corrections provide opportunities to harvest losses while staying invested. By reinvesting in similar assets, you can maintain your portfolio’s exposure without violating the wash-sale rule.
3. After a Portfolio Review
- Regular portfolio reviews often reveal underperforming assets that may no longer align with your goals. Selling these investments can create tax savings and improve portfolio performance.
How to Implement Tax-Loss Harvesting
Step 1: Identify Losses
Review your taxable accounts to identify investments with unrealized losses.
Step 2: Match Gains and Losses
Pair losses with gains to reduce your overall tax liability.
Step 3: Reinvest Strategically
Replace sold investments with similar assets to maintain your portfolio’s diversification and alignment with your goals.
Benefits and Drawbacks
Benefits
• Reduces taxable income or offsets gains.
• Allows for portfolio rebalancing without incurring additional tax burdens.
• Can create future tax savings by carrying forward unused losses.
Drawbacks
• Wash-Sale Rule: Can complicate reinvestment strategies.
• Transaction Costs: Frequent trades may result in fees.
• Timing: Requires monitoring markets and portfolio performance.
Advanced Strategies
1. Combine With Tax Gain Harvesting
- In years of lower income, consider harvesting gains alongside losses to take advantage of lower tax rates.
2. Leverage Automated Tools
- Many robo-advisors and portfolio management platforms offer automated tax-loss harvesting, which can simplify the process and ensure compliance with IRS rules.
3. Offset Ordinary Income
- Using losses to offset up to $3,000 of ordinary income can provide additional savings, particularly for high earners.
Common Misconceptions About Tax-Loss Harvesting
1. “It’s Only for the Wealthy”
- Tax-loss harvesting benefits anyone with taxable investments, regardless of account size.
2. “I Can Just Repurchase the Same Investment”
- The wash-sale rule prevents this. In my experience, choosing similar but not identical investments ensures compliance while maintaining your portfolio’s strategy.
3. “It’s Not Worth the Effort”
- While it requires planning, tax-loss harvesting can result in significant savings over time, especially for investors in higher tax brackets.
FAQs About Tax-Loss Harvesting
1. Can I Use Tax-Loss Harvesting in My IRA?
- No. Tax-loss harvesting applies only to taxable accounts, as gains and losses within tax-advantaged accounts like IRAs are not taxed.
2. How Much Can I Deduct?
- You can deduct up to $3,000 of net losses against ordinary income annually, with the remainder carried forward to future years.
3. Does It Make Sense in a Low-Income Year?
- Yes. Even in low-income years, harvesting losses can reduce your taxable income or offset future gains.
Conclusion
Tax-loss harvesting is a valuable tool for reducing your tax liability and improving your portfolio’s efficiency. By understanding the rules, timing your trades strategically, and reinvesting wisely, you can turn market volatility into a long-term advantage.
👉 Want to learn how to retire without the worry of running out of money in retirement? Click here to watch this video
Sources:
[1] https://www.fidelity.com/viewpoints/personal-finance/tax-loss-harvesting
[2] https://www.investopedia.com/articles/taxes/08/tax-loss-harvesting.asp
[4] https://www.reddit.com/r/investing/comments/1gpmq17/how_to_strategically_think_about_taxloss/
[5] https://www.schwab.com/learn/story/how-to-cut-your-tax-bill-with-tax-loss-harvesting
[7] https://www.firstcitizens.com/wealth/insights/tax-planning/tax-loss-harvesting
[8] https://am.gs.com/en-us/institutions/campaign/tax-loss-harvesting-strategies-how-they-work
Disclaimer: Case studies are hypothetical and do not relate to an actual client of Lock Wealth Management. Clients or potential clients should not interpret any part of the content as a guarantee of achieving similar results or satisfaction if they engage Lock Wealth Management for investment advisory services.