How Tax-Loss Harvesting Can Work for You

tax loss harvesting

How Tax-Loss Harvesting Can Work for You

Tax-loss harvesting involves selling investments that have lost value and replacing them with similar — but not identical — assets to maintain your portfolio’s balance while creating tax advantages. For example, you might sell a stock or mutual fund that has decreased in value and reinvest in a comparable security. Investments eligible for this strategy include stocks, bonds, real estate, businesses and other significant assets. It’s especially effective for assets that no longer align with your goals, have limited growth prospects or can be easily replaced.

How it works

When you sell an investment at a loss, the loss can be used to offset taxable capital gains from other investments or to reduce up to $3,000 of ordinary income annually on your federal taxes. If losses exceed these limits, they can be carried forward, continuing to reduce your tax liability in future years.

Capital gains and losses are classified as “short term” or “long term” based on how long you held the investment. “Short term” applies to assets held for one year or less, while “long term” applies to those held for more than a year. These classifications matter because they are taxed differently.

Short-term gains are taxed at your regular income tax rate, which can reach 37%, with an additional 3.8% Net Investment Income Tax for high earners, pushing the effective rate to 40.8%. Long-term gains are taxed at lower rates — 0%, 15% or 20% — depending on your income, though the NIIT can increase the rate to 23.8% for high earners.

You can use tax-loss harvesting to leverage these tax differences to your advantage. When you sell investments that have lost value, you offset gains in the same category. For example, short-term losses are first applied to short-term gains, which are taxed at higher rates. If you still have short-term losses after offsetting all short-term gains, the losses can then be used to offset long-term gains, providing additional tax savings. Similarly, long-term losses are applied to long-term gains first, helping minimize your tax liability in the lower tax bracket.

Key rules

To take full advantage of tax-loss harvesting, it’s essential to follow the IRS’s rules, particularly the wash-sale rule. This rule prohibits repurchasing the same or a “substantially identical” security within 30 days (before or after) of selling it for a loss. For example, if you sell shares of a stock to harvest a loss, buying the same stock within the restricted period would void the tax benefits. IRS Publication 550, Investment Income and Expenses, provides guidance on what is considered substantially identical.

The tax code allows individual filers to use up to $3,000 in capital losses per year to reduce ordinary income after offsetting gains. The limit is the same for joint filers. Any losses exceeding this amount are carried forward to future years, allowing you to benefit from tax-loss harvesting over the long term. For example, if you have $5,000 in losses after offsets, you can apply $3,000 to the current year’s income and carry forward $2,000.

Tax-loss harvesting is most effective when it’s part of your regular portfolio management. Periodically review your investments to identify underperforming assets or those that no longer align with your financial goals. Be sure to consult with a tax adviser or financial professional to ensure your strategy complies with IRS regulations and maximizes your potential savings.

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