Few of us like the idea of losing money on our investments. However, there are times when you need to sell a losing investment in order to prevent further financial pain. Or you might want to sell an underperforming investment as part of rebalancing your portfolio. No matter your motive, in situations like these, tax loss harvesting can be a lifesaver – or, rather, a money saver.
At its core, tax loss harvesting is a strategy based on selling stocks, mutual funds, exchange-traded funds and other securities that are now worth less than what investors paid for them and are experiencing losses. This is a long-term incremental strategy, which makes it perfect for young investors such as Millennials.
The loss on the sale can offset gains from the sale of other securities — at least partially — or create a deduction against ordinary income.
Benefits of Tax Loss Harvesting
There are three benefits to tax loss harvesting:
- Tax losses are effectively an interest-free loan that defers capital gains taxes you would otherwise owe in the future. It is possible in some situations to eliminate them entirely when you die.
- After offsetting realized gains, you can use any remaining tax losses to deduct $3,000 from your income taxes each year.
- Any losses that remain can be rolled over into future years until all of your losses are used up. You can defer your capital gains.
One of the main goals of harvesting losses is to offset gains in investment securities with realized losses and use any remaining loss to offset up to $3,000 of ordinary income. Losses beyond the $3,000 limit may be carried over to succeeding years.
In recent years, more and more large brokerage firms and fund companies have begun giving customers performance data on their investments that they need for tax loss harvesting. Also, some robo advisors offer the auto-reporting aspect of tax loss harvesting. These include platforms that we here at Investor Junkie have reviewed, such as Wealthfront and Betterment.
How Tax Loss Harvesting Works
Tax loss harvesting is fairly straightforward. First of all, you determine your long-term gains and your short-term gains, then use your capital losses to offset your gains.
Match up your long-term losses with your long-term gains, and use your short-term losses to offset your short-term gains. If everything matches up with one type of gain, you can apply the excess to another type of gain.
Consider the following situation with your taxes:
- $3,000 in short-term capital gains
- $4,000 in long-term capital gains
- $5,000 in short-term capital losses
- $3,000 in long-term capital losses
Your first move is to take the $5,000 in short-term losses to offset the $3,000 in short-term gains. Now you have $2,000 left in short-term losses. Next, you apply the $3,000 in long-term capital losses to the $4,000 in long-term capital gains.
As you can see, that leaves $1,000 in capital gains to be taxed on. Since there is leftover money from the short-term assets, you apply that toward your long-term capital gains. Now you have an extra $1,000 in losses for deductions, and you don’t owe any tax on your capital gains for the year.
Another feature of tax loss harvesting is you can use anything extra, after offsetting your capital gains, to reduce other income. So that extra $1,000 can be used as a deduction against your earned income. There is a cap on how much you can reduce your earned income by, though. You can use only a maximum of $3,000 in losses to offset your earned income.
However, you can carry forward unused losses indefinitely. So if you had an extra $5,000 after settling out your capital gains, you can put $3,000 of it toward reducing other income and then carry forward the remaining $2,000 for use next year.
A Good Strategy for Millennials
The tax loss harvesting strategy makes better sense for young investors than, say, for someone who is close to retiring. This is because there are more years in which losses can be offset. If you still like a security after you sell it to take advantage of tax loss harvesting, you can buy it back. Just wait 30 days between the sale and repurchase to satisfy the “wash sale” rule (we’ll get to that in a moment).
Due to the “go around” nature of this process, there are restrictions and nuances to this strategy. There are also different points in time when these strategies will make more sense — specifically, such as when you may want to offset taxable income in the future.
Now, if you decide to take advantage of tax loss harvesting, make sure you pay attention to an important rule established by the IRS.
The Wash Sale Rule
According to the IRS, investors are not allowed to deduct losses from sales of securities in a wash sale. A wash sale occurs when you sell securities at a loss and, within 30 days buy substantially identical assets.
For example, you can’t sell the stock in your taxable account and then turn around and repurchase it in your IRA — or even in your spouse’s IRA. The point of the rule is to prevent investors from selling an asset that has dropped in price — thus reducing their tax liability — and then buying that asset at a lower price to take advantage of a price gain later.
When Not to Harvest Losses
There are scenarios in which tax loss harvesting isn’t a good idea. So be sure to evaluate your entire financial picture first. The key to this strategy is to understand the tax rates before you tax loss harvest. For example, if your capital gains tax rate is 0%, taking a loss on one equity to offset a gain on another could actually lose you money.
In a way, a tax loss harvest can be thought of as a loan from the IRS. For example, if the funds generated by the sale are reinvested in the same or similar securities (after waiting 31 days to avoid a wash sale), then the transactions have resulted in a lower basis. However, in the end, if the asset price of that security increases you will pay taxes on capital gains when you sell. Therefore, the tax loss harvest tax benefit ultimately could result in a higher capital gains taxes in a future year than you might have otherwise incurred.
Which Robo Advisors Offer Tax Loss Harvesting?
To try this strategy with the help of robo advisors, here’s a list of platforms we’ve reviewed that offer tax loss harvesting:
|Robo-Advisor||Annual Fees||Minimum Deposit|
|Betterment||Digital – 0.25%/year; Premium – 0.40%/year||$0|
|Charles Schwab Intelligent Portfolios||None||$50,000|
|Hedgeable||0.30% – 0.75%/year — Depends upon amount deposited||$0|
|OpenInvest||0.50% (plus an additional 0.22% if you opt for the green bond fund)||$3,000|
|SigFig||First $10k managed free; 0.25%/year for $10k+; 0.50% for Diversified Income Portfolio||$10,000|
|Wealthfront||First $10k managed free; 0.25%/year for $10k+||$500|
|Wealthsimple||Under $5k – FREE; $5k-$100k – 0.50%/year; $100k+ – 0.40%/year||$0|
|WiseBanyan||None — Basic services are free||$0|
Do you have holdings that are experiencing losses? See if tax loss harvesting will offset them!