Tax-Loss Harvesting: A Smart Strategy to Lower Your Tax Bill

Investing always involves some degree of risk, and not every investment will generate a profit. However, even when an investment loses value, it can still provide a valuable tax-saving opportunity through a strategy known as tax-loss harvesting. This technique allows investors to sell underperforming investments at a loss to offset capital gains or other taxable income, potentially reducing their tax bill.

What is Tax-Loss Harvesting?

Tax-loss harvesting is the practice of selling investments that have lost value to realize a capital loss. The loss can be used to offset capital gains from the sale of other investments. If your losses exceed your gains, you can also use them to offset up to $3,000 of ordinary income per year (or $1,500 if married and filing separately), with any remaining losses carried forward to future years.

By strategically realizing these losses, you can lower your overall tax liability while keeping your portfolio on track.

How Does Tax-Loss Harvesting Work?

Let’s break it down:

1. Sell a Losing Investment: If you have an investment that has decreased in value, you can sell it to realize the capital loss. For example, if you originally bought a stock for $10,000 and it’s now worth $7,000, selling it would result in a $3,000 loss.

2. Use the Loss to Offset Gains: If you also sold another investment during the year for a profit, you can use that $3,000 loss to offset the taxable gain. This can reduce or even eliminate the capital gains taxes you’d otherwise owe.

3. Offset Ordinary Income: If your losses exceed your gains, you can use the excess loss to offset up to $3,000 of ordinary income for the year, potentially lowering your overall tax bill.

4. Carry Forward Losses: If your capital losses exceed both your capital gains and the $3,000 annual limit for offsetting ordinary income, you can carry forward the remaining losses to future tax years. These losses can continue to offset gains or income until they are fully used up.
   

The Wash-Sale Rule: Avoiding Pitfalls

One important thing to keep in mind when implementing tax-loss harvesting is the wash-sale rule. The IRS disallows claiming a loss on the sale of a security if you buy a “substantially identical” security within 30 days before or after the sale. This means you can’t sell a stock to claim the tax benefit, then immediately repurchase it.

To stay compliant with the wash-sale rule, you can:

• Wait 31 Days: After selling the losing investment, wait at least 31 days before repurchasing the same or a substantially identical security.

• Buy a Similar Investment: Instead of repurchasing the same stock or security, consider buying a similar but not identical investment (such as an exchange-traded fund or ETF that tracks the same sector or industry).
  

Benefits of Tax-Loss Harvesting

1. Reduce Capital Gains Tax: By offsetting your capital gains with losses, you can minimize or eliminate the amount of tax owed on profits from other investments.

2. Offset Ordinary Income: In addition to offsetting capital gains, tax-loss harvesting allows you to reduce up to $3,000 of taxable income per year. This can provide extra savings, especially if you’re in a higher income tax bracket.

3. Compound Tax Savings Over Time: Tax-loss harvesting can be an ongoing strategy, with losses carried forward year after year, providing tax relief well into the future as you continue managing your investment portfolio.
   

When Should You Consider Tax-Loss Harvesting?

Tax-loss harvesting is typically most effective in years when you have significant capital gains from the sale of stocks, bonds, or other investments. It can also be a good idea if you have high ordinary income and are looking to offset a portion of it with losses.

While the end of the year is a common time for investors to review their portfolios and harvest losses, it’s a strategy that can be implemented throughout the year, especially in times of market volatility when some investments may decline in value.

Does Tax-Loss Harvesting Make Sense for You?

Not every investor will benefit equally from tax-loss harvesting. For instance, if you’re in a lower tax bracket, the savings might be minimal. However, if you’re subject to higher capital gains tax rates or have significant taxable investment income, it can be a highly effective tool to reduce your tax burden.

Additionally, tax-loss harvesting should be considered within the broader context of your overall investment strategy. While the tax benefits are clear, it's essential to ensure that your portfolio remains aligned with your long-term financial goals, even if you sell certain assets at a loss.

The Bottom Line

Tax-loss harvesting is a savvy way to turn a market downturn into a tax-saving opportunity. By strategically realizing losses and reinvesting in a way that maintains your portfolio’s long-term potential, you can reduce your tax burden and keep more of your investment returns.

At RETIRESIMPLY™, we specialize in creating comprehensive tax strategies to help you pay less tax in retirement. Our planners can work with you to determine if tax-loss harvesting fits into your overall financial plan, ensuring you make the most of your investments while keeping taxes to a minimum.