What is tax-loss harvesting?
When you sell a profitable stock or receive a dividend, or even if a mutual fund you own sells some of its investments at a profit, you’ll owe capital gains taxes when you file your federal return for that year. Tax-loss harvesting lets you manage your tax burden by selling securities like stocks, bonds, mutual funds and ETFs at a loss to offset the taxes owed on capital gains elsewhere in your portfolio. You can even use tax-loss harvesting to offset taxes owed on regular income.
Short-term vs. long-term capital gains
If you’ve held a security for at least a year and sell it for more than you paid, you’ll owe long-term capital gains tax (which ranges from 0% to 20%, depending on your income) on the profit. If you held the investment for less than a year, you’ll have short-term capital gains, which are taxed as regular income.
Tax-loss harvesting can offset either type of gain, but if you have both, consider using the strategy toward short-term gains first because they’re usually taxed at a higher rate.
Tax-loss harvesting rules
Not surprisingly, the IRS has added a number of caveats to the tax-loss harvesting rules. For example, you’re allowed to reinvest in the same (or “substantially identical”) securities you sold at a loss. But if you want to harvest that tax loss (to offset gains), you have to wait at least 30 days to avoid a “wash sale.”
Not all the rules limit you, though. For instance, if you offset all your capital gains (and/or up to $3,000 in taxable income Opens in new window) in a given year and still have losses left over, you can carry over the excess amount into the next year. In fact, this carryover can occur indefinitely, until you’ve applied your entire loss to future gains and income.
How tax-loss harvesting can help manage your taxes
Tax-loss harvesting offers the biggest benefit when you use it to reduce regular income, since tax rates on income typically run higher than rates on long-term capital gains. Even if you don’t have any capital gains in a given year, you can use up to $3,000 in capital losses to lower your income tax.
Some people time their sales to late December, to get a clearer picture of their gains and potential losses for the year. But you don’t have to do that. You can take the loss any time during the year.
Even so, if your investments are in tax-deferred retirement accounts, like traditional 401(k)s or IRAs, you can’t take advantage of tax-loss harvesting. The reason: You don’t “realize” capital gains (or owe taxes) on investments within those accounts until you withdraw from them, typically in retirement.
When tax-loss harvesting may not be worth it
To secure a capital loss (and tax break), you’ll need to sell securities. This might result in fees—as could repurchasing the securities (at least 30 days later). So, unless any taxes you’ll save will exceed any sales fees you’ll pay, you may want to avoid the tactic.