If you’re an investor with a taxable investment account, you should know about tax-loss harvesting. Tax-loss harvesting enables investors to take advantage of market fluctuations to capture a tax loss on investments, offsetting future capital gains taxes.
Tax-loss harvesting can be done manually, but it’s easiest with the help of a computer or fully automated robo advisor. Here’s a more detailed look at how tax-loss harvesting works, and how you can put it to use to save on taxes.
The Short Version
- Tax-loss harvesting is when you sell an investment at a loss and immediately re-buy a similar investment.
- This strategy locks in the investment loss for tax purposes.
- However, there are limits to this strategy, including how much you can claim and rebuying the same investment, known as the wash sale rule.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is an investment strategy of selling investments at a loss and immediately re-buying a similar investment to lock in an investment loss for tax purposes. After tax-loss harvesting transitions, your portfolio should have a nearly identical allocation. The only cost, if any, is transaction fees.
However, depending on your income and tax situation, you could wind up significantly better off when taxes are due. When you have a realized gain in the future in a taxable account, you'll be glad you used the tax-loss harvesting strategy.
Tax-loss harvesting doesn’t mean you’ve made bad investments or will lose in the long term. Even highly successful investors like Warren Buffett see ups and downs in their portfolios over time. Employing tax-loss harvesting techniques may help you lower your tax bill when you sell with a capital gain.
If you're looking for personal tax advice, consider working with a trusted financial advisor or other tax professional. You don't want to accidentally wind up with tax penalties or pay too high of a tax bill for your investment income.
Find out more >>> Best Tax Software for Investors
Example of Tax-Loss Harvesting
Here's an example to help you better understand how tax-loss harvesting works. Let’s say you buy $10,000 of the S&P 500 index fund, iShares Core S&P 500 exchange-traded fund (ETF), and look back at your portfolio a year and a half later and see it is now worth $8,000. You think the market is still going up in the long run and want to keep the investment. That’s where your tax-loss harvesting opportunity comes in.
You can sell the index fund and quickly buy another broad market index fund, like the Vanguard Total Stock Market Index Fund ETF — which follows the same index and charges the same fees. Once the sale is final, you can claim $2,000 in long-term tax losses and are essentially in the same position as you started.
Tip: Automated tax-loss harvesting apps take care of this hard work for you.
When Could Harvesting Losses Make Sense?
Tax-loss harvesting transactions can take place at any time. If your portfolio is in a position where you’re holding an investment at a loss, you may be able to employ tax-loss harvesting. Any sale must be completed by the end of the tax year (Dec. 31) to be eligible to use this loss harvest technique to offset a capital gain.
Harvesting tax losses works best when holding a diverse portfolio of index funds with comparable alternatives available. You may have a more challenging time finding similar alternative investments.
When preparing your annual tax return, your tax accountant or software aggregates all of your investment transactions for the year. Gains are taxable, and losses derived from tax-loss harvesting may offset capital gains. If you sold investments for a $3,000 profit and had $1,000 of tax losses from harvesting transactions, you would pay taxes as if you had made $2,000. If your losses are more than your gains, you may carry those losses over to the next year in most cases.
Limitations to Tax-Loss Harvesting
This may have you scheming that you can sell and repurchase your entire investment portfolio when it’s down to offset capital gains. It’s not quite that simple. According to IRS rules, you can’t sell and repurchase the same investment within 30 days and claim the tax loss.
These are the most important limitations to know about when dealing with tax-loss harvesting:
- Wash sale rule: The wash sale rule says you can’t sell and rebuy the same or “substantially identical” investment. Take this rule in mind when swapping for a different mutual fund. Find out more in our Wash Sale Rule Guide.
- Annual limits: Tax losses may only be claimed up to a specific limit, depending on your tax filing status. The maximum limit is $3,000 per year.
- Short-term and long-term matching: A short-term loss offsets short-term capital gains, and the same goes for long-term gains. You may have to use your long-term capital gain balance first if you’re coming into a situation with capital loss carryovers. Remember, short-term gains are taxed as ordinary income. That's often at a higher tax rate.
Can Harvesting Losses Improve Your Investment Returns?
Tax-loss harvesting shouldn’t have a meaningful influence on your investment results. Your gains and losses will ultimately be similar either way. The big difference is noticeable on your tax return.
If you can save $500 per year on taxes due to tax-loss harvesting, that can quickly add up to tens of thousands of dollars in savings over the years, worth much more if you keep those savings in a well-performing investment account.
So, while tax-loss harvesting may not improve your investment results, it will improve how much money you have to keep after taxes. Depending on how you look at it, you could argue that better net results improve your investment results, but it won’t make stock prices go any higher.
Do Robo Advisors Offer Tax-Loss Harvesting?
Yes, many robo advisor platforms will harvest tax losses for their clients automatically. This allows investors to capitalize on tax-saving opportunities without manually buying and selling securities or having to worry about steering clear of the wash sale rule.
Here are three robo advisors we recommend that include automatic tax-loss harvesting with their custom portfolios.
|Robo-Advisor||Annual Fees||Minimum Deposit|
|Digital – 0.25%/year; Premium – 0.40%/year||$0|
|Wealth Management: First $1 million: 0.89% ; $1-3 million: 0.79%; $3-5 million: 0.69%; $5-10 million: 0.59%; Over $10 million: 0.49%||$100,000|
The Bottom Line
Tax-loss harvesting isn't necessary in a retirement account where you don’t pay any taxes until you withdraw from the account. This strategy is best with taxable investment accounts. If you have this kind of account, particularly with a fund-based strategy, you’re in an excellent position to take advantage of tax-loss harvesting, which can be a huge tax benefit.
If selling and buying stocks and funds yourself isn’t your idea of fun, consider a tax-loss harvesting strategy with a robo advising service that includes automatic tax-loss harvesting. That can be an excellent tax saving plan for this tax year and many more to come.
Read more: Best Robo Advisors