Key Takeaways
- Tax-loss harvesting involves offsetting capital gains with capital losses so that little or no capital gains tax comes due.
- Investors might intentionally sell some securities at a loss to achieve this when they have significant gains.
- Losses can offset regular income by up to $3,000 when they exceed gains.
- Any losses over the $3,000 threshold can be carried forward into future tax years.
Definition and Example of Tax-Loss Harvesting
Tax-loss harvesting can be valuable to an individual who invests in taxable brokerage accounts, as a means of either reducing or eliminating capital gains or reducing ordinary taxable income. The strategy isn’t appropriate for tax-deferred accounts like 401(k) or IRA accounts, because the original investment and earnings already grow tax-free in those accounts.
It’s all about balancing gains with losses. A capital gain occurs when you sell a security like a mutual fund or ETF for more than its purchase price. You would incur a capital loss if you were to sell an asset for a lower price than that at which you bought it. You don’t truly realize the gain or loss on any security as a taxable event until you sell it.
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You have an unrealized gain or loss based on the security’s current value and an increase or decrease in investment value on paper before you actually sell.
You’ll owe capital gains tax if you have a gain. Long-term capital gains on securities that are held for over one year are taxed at lower rates. A maximum rate of 20% applies, but most taxpayers will pay zero in capital gains tax or a 15% rate.
You’ll have a short-term capital gain if you sell a security you’ve held for one year or less. These are taxed at higher ordinary income tax rates.
How Tax-Loss Harvesting Works
Suppose you invested $1,000 in Fund A and $1,000 in Fund B two years ago. Fund A is now worth $1,500, and Fund B is worth $500. You’ll realize a $500 capital gain on Fund A and a $500 capital loss on Fund B when you sell. The gain and loss would offset each other, so you wouldn’t owe any tax.
Now suppose that you invested $6,000 each in Fund A and Fund B, but Fund A is worth $7,000 now, and Fund B is worth $2,000. You would have a capital gain of $1,000 and a loss of $4,000. This would result in a net loss of $3,000. You wouldn’t owe any tax on the gain. You could also reduce your taxable income by that $3,000.
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The key to a harvesting strategy is to pay attention to the fair value of one share of the security. This is also known as the “net asset value” (NAV).
What It Means for Individual Investors
Tax-loss harvesting isn’t without its potential pitfalls:
- Be aware of the “wash-sale” rule. Some investors like to buy back the same fund that they earlier harvested or sold, but the IRS rule surrounding wash sales stipulates that you can’t deduct the loss if you sell a security at a loss and buy a “substantially identical” security within 30 days before or after the sale. An exception applies if you incurred it in the course of doing ordinary business.
- Don’t confuse tax-loss harvesting with capital gain distributions, which are those that a mutual fund pays from its net realized long-term capital gains. You can use losses to offset these capital gains distributions, but you can’t use them to offset distributions of net realized short-term capital gains. These are treated as ordinary dividends rather than capital gains.
- A wise investor can also reduce taxes in a regular brokerage account by reducing income from dividend-paying mutual funds and taxes from capital gains distributions through a strategy called “asset location.” You can place tax-efficient investments that generate little to no income within taxable accounts.
- Tax-loss harvesting is a year-round activity. It’s often a year-end investment strategy. A savvy investor should be mindful of all fund purchases and sales throughout the year. Make investment decisions based on financial objectives, not market whims.
Do I Have to Pay Capital Gains Tax?
You’ll only pay capital gains tax on “net gains,” which are your gains minus your losses. You can use a capital loss to offset a capital gain if your gains exceed your losses. You can reduce your taxable income by the lesser of $3,000 or your total net losses if your losses exceed your gains during the tax year. You can only reduce your taxable income by up to $1,500 in losses if you’re married and file a separate tax return.
An investor can carry forward and apply any unused losses to future tax years if net losses exceed $3,000.