What Is Tax-Loss Harvesting?
Investors can deduct capital losses from their capital gains and selling investments to "harvest" losses can be a helpful strategy. Here's how it works.
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Tax-loss harvesting is the strategic selling of investments for a loss to benefit from tax deductions. When you make money from investing, you have to pay taxes on your profits. But when you sell losing investments, you can deduct the losses from your investment gains, and a limited portion from your ordinary income as well.
How do income taxes work with investments?
Before diving into more details about tax-loss harvesting, it's helpful to have a high-level understanding of capital gains taxes—the taxes you pay on the profits from your investments.
When you buy an investment, such as a stock, bond, mutual fund or exchange-traded fund (ETF), the price you pay (minus fees or commissions) is your cost basis. When you sell the investment, you'll have to report the difference between your cost basis and the sale price on your tax return for the year.
If you hold the investment for at least a year, you'll pay short-term capital gains on the profits—which have the same tax rates as your ordinary income tax rates. If you held it for longer than a year, then you pay the long-term capital gains tax rates, which may be lower.
When you sell an investment for less than your cost basis, you can deduct the loss from your taxable income.
What to know about tax-loss harvesting
While tax-loss harvesting might help you lower your tax bill for the year, there are a few details to keep in mind:
- Losses offset similar types of gains. Your capital losses have to initially match the types of gains that they're offsetting. For example, if you have $1,000 in short-term gains, $2,000 in long-term gains and $1,500 in short-term losses, then you can deduct $1,000 from your short-term gains and $500 from your long-term gains. When you have more capital losses than gains, you can deduct up to $3,000 in losses ($1,500 if you file using the married filing separately status) from your ordinary income each year. You can then roll over any remaining capital losses to the next year.
- Don't wait until the last minute. Tax-loss harvesting is something you need to do before the end of the year because the capital gains and losses are locked in place during the year you sell the investment. For example, the gains and losses from sales in 2022 will impact the tax return you file in 2023.
- You can only offset gains from taxable accounts. You don't report or pay taxes on the gains from selling investments that are in a 401(k), IRA or other types of tax-advantaged account right away, so you can't offset these with capital losses and won't benefit from tax-loss harvesting.
- Wash-sale rules apply. If you sell an investment for a loss and then rebuy it or buy a contract or option to buy a "substantially identical security" within 30 days, the wash-sale rule applies. As a result, the loss will be added to the cost basis of the asset you buy (which can lower your taxable gains later), but you don't take a tax deduction this year. The rule applies even if you buy the investment in a different account, including a traditional or Roth IRA.
- You can repurchase similar types of investments. While the wash-sale rule applies to substantially identical securities, you can purchase somewhat similar investments (such as a competitor's stock) to keep your overall portfolio in line. Some robo-advisors use this approach and automatic tax-loss harvesting to help optimize clients' gains.
You'll also want to consider how much you'll actually benefit from capital losses. For example, if you're unmarried and make less than $41,676 in 2022, your capital gains tax rate is 0%. While you might want to sell losing investments for other reasons, you won't benefit from the tax loss this year.
Should you harvest losses?
Tax-loss harvesting could be a silver lining if you're selling an investment for a loss, but try to keep your overall plan and long-term investment goals in mind. While selling solely to harvest taxes might be a good idea in some cases, you may want to discuss the options and alternatives with an investment advisor before making a decision. Sometimes, continuing to hold on might be the better move.
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