Is Tax-Loss Harvesting for You? Ask These Four Questions

No one enters the investment world intending to lose money. But by the same token, well-diversified portfolios often contain under-performing investments. The good news is, there's a way to use those “losers” to save on taxes by employing a practice known as tax-loss harvesting.

What is tax-loss harvesting?

Tax-loss harvesting involves selling an investment for a loss to offset gains from investments sold at a profit. This can reduce your tax bill, since you’re only paying on your net profit, which is the amount you’ve gained minus the amount you lost.

Granted, the process of intentionally selling for a loss can seem a bit counterintuitive. But most investors don't use it as a way to eliminate their exposure permanently. Instead, they use the sale to reduce their tax bill, then reinvest the returns in a similar industry or sector to keep their asset allocation and risk profile unchanged. (After a 30-day waiting period, they can also reinvest in the same stock. But more on that in a moment.) 

Tax-loss harvesting can be a valuable strategy for those invested in taxable brokerage accounts, either as a means of reducing or eliminating capital gains or reducing ordinary income. Even if there are no gains to offset, the IRS allows single filers and married couples filing jointly to deduct up to $3,000 in capital losses from ordinary income each year. Any losses beyond $3,000 can be carried over and deducted in subsequent tax years. 

It’s important to remember that tax-loss harvesting generally isn’t appropriate for tax-deferred accounts like 401(k)s or IRAs, since the original investment and earnings are already growing tax deferred (in traditional IRAs) or tax-free (in Roth IRAs).

Are the savings worth it?

The amount of money you can save through tax-loss harvesting depends both on your tax bracket and the nature of the gains you’re trying to offset. For example, when you sell a stock or other investment, the IRS taxes whatever profits you earn. But different rates apply depending on the length of time you’ve owned the investment. For any investments you’ve held for a year or less, short-term capital gains tax rates apply. These are same rates that apply to regular income, like salary and wages. These rates, ranging from 10% to 37%, are higher than the rates on investments you’ve held for more than a year; long-term capital gains tax rates run from 0% to 20% (effectively 23.6% when a Medicare surtax is applicable). 

While many investors look for tax-loss harvesting candidates in their portfolio near the end of the year, harvesting opportunities exist year-round. After all, investments can fluctuate dramatically, and a tax-loss harvesting opportunity that looks attractive in June may well be gone by the end of the year.

What are the rules?

Remember that 30-day waiting period we mentioned? That's due to the "wash sale" rule. This rule states that an investor can't sell a stock to realize a loss and minimize their tax burden, then rebuy that same stock within 30 days. The rule actually goes further and states that an investor also can't buy a new security that is "substantially identical." For instance, if you sold shares of Pfizer to claim a loss, you can't turn around and buy new Pfizer shares within 30 days. You could, however, buy shares of Merck, or invest in an industry-specific ETF or mutual fund. Or, at the end of 30 days, you could buy back the original shares with no tax penalty. 

If you’re hoping to rebound a stock, the wash sale rule can make it difficult to harvest those tax losses. But the IRS hopes these measures will help prevent abuse of the tax-loss harvesting strategy.

Are you a good candidate?

Generally speaking, tax-loss harvesting is most advantageous for those who buy and sell investments on a regular basis. Infrequent or casual investors may not even have enough capital gains for it to be a factor. That said, it's a great strategy for individuals who know how to use it properly – offsetting capital gains tax obligations while minimizing losses.

It is wise to explore all options for reducing your taxes. To make sure you're making the most of all opportunities, consult with a tax professional or financial adviser who can review your financial goals and guide you toward the most appropriate and beneficial tax strategy.

Hunter Yarbrough, CPA, CFP, is a vice president and financial adviser with CapWealth. He is passionate about taking a holistic view of personal finance, including investments, taxes, retirement, education, estate planning, and insurance. For more information about Hunter and CapWealth, visit capwealthgroup.com.