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How Tax-Loss Harvesting Can Lower Your Tax Bill

Apr 13, 2021 3 min read Deborah Adams Kaplan

Key takeaways

  • Tax-loss harvesting can help you lower your taxes by selling losses to cover gains.
  • You can use investment losses to offset capital gains taxes or up to $3,000 in income each year.
  • You must follow IRS rules to use this technique properly and legally.

 

Every spring, after tax time, you might think about what you could have done differently to lower the amount you owed to Uncle Sam. A strategy called tax-loss harvesting may offer a solution. It lets you use losses on certain investments to offset capital gains—and resulting taxes—on others. Here’s what you need to know.

 

 

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.

 

What you can do next

Take a look at your investments and see if you have opportunities to take advantage of tax-loss harvesting. But understand that while the strategy works for many situations, it shouldn’t be the only tool in your tax-efficient investing shed. Different tactics could result in greater tax savings, so consider talking to a financial professional or tax advisor before you make your moves.

Footnotes

Deborah Abrams Kaplan covers personal finance and insurance for a variety of publications and brands.

 

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