Key Takeaways
- Sell investments at a loss to reduce taxes.
- Losses offset capital gains and ordinary income.
- Must avoid repurchasing identical securities within 30 days.
- Carry forward unused losses to future tax years.
What is Tax Loss Harvesting?
Tax loss harvesting is a strategy where you sell investments at a loss to offset capital gains or reduce taxable income, lowering your overall tax burden. This approach leverages the tax code’s treatment of gains and losses to improve after-tax returns.
By realizing losses on certain assets, you can balance gains from others, helping manage your portfolio’s tax efficiency without significantly altering your market exposure.
Key Characteristics
Tax loss harvesting involves strategic selling and reinvesting to optimize tax outcomes. Key features include:
- Offsetting gains: Realized losses reduce taxable gains from profitable investments.
- Income reduction: Excess losses beyond gains can lower ordinary income by up to $3,000 annually.
- Carryforward provision: Unused losses can be carried forward indefinitely to future tax years.
- Reinvestment: Proceeds are reinvested in similar securities like IVV or SPY to maintain portfolio allocation.
- Wash sale rule: Selling and repurchasing the same or substantially identical security within 30 days is disallowed for tax purposes.
How It Works
You begin by selling an underperforming asset at a loss, which generates a realized loss you can apply against gains from other sales. For example, if you have gains from a profitable stock, you can offset those gains by harvesting losses on another security to reduce your tax liability.
After selling, you reinvest the proceeds in a similar investment—such as VYM—to keep your portfolio aligned with your goals while adhering to the wash sale rule. This approach helps you stay invested in the market while optimizing your tax position.
Examples and Use Cases
Tax loss harvesting works well in various market environments and sectors. Here are some practical illustrations:
- Index funds: Selling shares of SPY at a loss and replacing them with IVV maintains exposure to the S&P 500 while capturing tax benefits.
- Dividend-focused ETFs: You might harvest losses on VYM if it underperforms, then reinvest in a similar dividend ETF to preserve income streams.
- Sector rotation: Applying tax loss harvesting within sectors by switching between comparable ETFs or stocks can optimize both tax and portfolio performance.
Important Considerations
While tax loss harvesting can reduce your tax bill, be mindful of the sale timing to avoid the wash sale rule, which disallows claiming losses if you buy back the same security within 30 days. This requires careful trade planning to ensure compliance.
Additionally, transaction costs and the complexity of managing losses versus gains should be weighed against potential benefits. Consulting with a tax professional can help align harvesting strategies with your overall tax situation and investment objectives.
Final Words
Tax-loss harvesting can meaningfully reduce your tax bill by offsetting gains and lowering taxable income. Review your portfolio to identify potential losses you can realize without disrupting your investment strategy.
Frequently Asked Questions
Tax loss harvesting is a strategy where you sell investments at a loss to offset capital gains or reduce taxable income, helping to lower your overall tax bill.
You sell an underperforming investment below its original purchase price, use the loss to offset capital gains or ordinary income, and then reinvest in a similar security to maintain your portfolio balance.
The wash sale rule prevents you from claiming a tax loss if you buy the same or a substantially identical security within 30 days before or after selling it at a loss.
Yes, after offsetting capital gains, up to $3,000 of excess losses can be used each year to reduce ordinary income, with any leftover losses carrying forward to future years.
Trading costs from selling and buying investments can reduce tax benefits, and the strategy can be complex, so professional guidance is recommended to navigate tax rules effectively.
It helps lower your tax liability, allows you to spread losses across years, diversify your portfolio by replacing poor performers, and take advantage of down markets with reinvestment.
Yes, you can use tax loss harvesting annually to offset gains and reduce taxable income, carrying forward any unused losses to future tax years indefinitely.
