What is Tax-Loss Harvesting?

Tax-loss harvesting is like finding a silver lining…

When bad things happen, they can sometimes come with some consolation. Say you get laid off, but you finally have an opportunity to go on a road trip with your family.Tax-loss harvesting is a way to still get some benefit out of losing money on your investments.

The goal of tax-loss harvesting is to lower your taxes. When you sell investments, such as stocks, for a profit, you generally owe capital gains tax on your earnings. The rate you pay depends on how long you owned the investment and your income:

• Short-term capital gains are generally those you make on investments you held for a year or less. These are taxed according to your tax bracket, just like your regular income. In 2022, the highest marginal tax rate was 37% for individuals with incomes above $539,901, or married couples filing jointly with total income above $647,851. In 2023, individuals with incomes above $578,125 and married couples filing jointing with total income above $693,750 are in the 37% tax bracket.
• Long-term capital gains apply to investments you owned for more than a year. These are taxed at either 0%, 15%, or 20%, depending on your income.

If you also had investments that saw losses, selling those in the same year can help balance out the gains and reduce your capital gains taxes — this is called tax-loss harvesting.

If you have more losses than you need in a given year to balance gains and income, you can carry them forward to offset those in future years for as long as you want. If you’re interested in this strategy, you may want to talk to a tax professional. Before selling investments, you may want to weigh the benefit of reducing your taxes against your long-term investing goals.

Let’s look at a simple example:

On January 1, Emma buys 100 shares of MEOW stock and 100 shares of PURR stock, both at $15 a share (aka she spends $1,500 on each purchase). Throughout the year, MEOW does well, while PURR goes downhill.

On December 31, Emma sells all her MEOW shares at $20 a share, or $2,000. She made a profit of $500 and will have to pay short-term capital gains tax on that amount. To avoid this, she decides to sell PURR too. It’s trading at $10 a share, so she loses $500 on the investment. Between the gains and losses for these trades, her net capital gains are $0, so she likely doesn’t owe capital gains tax. If MEOW’s stock price had also dropped, Emma could still likely sell one of the losing investments to reduce her taxable income by up to $3,000.

A wash sale is when you sell or trade securities, like stocks, at a loss, but buy or trade to get basically the same securities within 30 days before or after the sale (purchasing a contract or option allowing you to buy the securities counts, too). It doesn’t have to involve exactly the same securities, but any that are “substantially identical,” according to the Internal Revenue Service. There’s no clear definition of “substantially identical,” so it’s often a judgment call.

The wash sale rule is an IRS regulation that says you can’t deduct losses (aka use tax-loss harvesting) when a wash sale is involved. The point of the wash sale rule is to discourage investors from selling securities just to get a tax benefit, then buying the same securities right away. If you invest automatically, for example by reinvesting dividends, it can be easy to break this rule without knowing it.

If the IRS finds that you violated the wash-sale rule, you don’t pay a penalty. But you can’t use those losses to offset gains in the short term, so you might pay more for taxes than you expected that year. However, the IRS lets you add the loss to the cost basis of the replacement stock you bought. If the stock price falls, that means you might be able to deduct a bigger loss if you sell it. Or if it rises, you may pay less in capital gains when you sell it.

If you are looking to avoid a wash sale but still want to own stock in a certain industry, one option might be to invest in a mutual fund or exchange-traded fund (ETF) that covers that sector but would not be deemed "substantially identical" or buy stock that is similar, but not “substantially identical.” You may want to talk to a tax professional to make sure you’re in the clear.

Cost basis is a fancy way of describing what you paid for an investment. This includes not only the purchase price, but also brokerage fees, commissions, and other trading costs. Your cost basis can change when a company you own stock in issues dividends, merges with another company, or takes certain other actions.

Knowing your cost basis is important because it’s part of calculating your capital gain. Specifically, your capital gain is the difference between your cost basis and the price you sell securities for.

Cost basis is also an important consideration when it comes to tax-loss harvesting. If you just buy stock all at once, and you don’t reinvest your returns, calculating your cost basis — and thus your capital gain — is pretty easy.

But some investors automatically reinvest dividends or buy shares over time. In that case you can choose from a couple of different methods for calculating cost basis:

• The average-cost method involves taking the average cost basis of all the shares you’ve bought.
• The actual-cost method involves tracking what you actually paid for each batch of shares.

The average-cost method is less of a hassle. But when you’re doing tax-loss harvesting, using the actual-cost method lets you identify specific shares to sell (the ones you paid the most for). By selling those, you can increase the amount of losses you can use to offset gains. Either way, you’ll need to keep good records of what you spent so that you can report cost basis accurately.

Anyone who has investment losses can consider using tax-loss harvesting. Since you can likely deduct losses against your income, you don’t need to be seeing massive investment gains to benefit.

But keep in mind that tax-loss harvesting only makes sense for investments in taxable accounts. If you gain or lose money on securities in tax-advantaged accounts, such as most retirement plans or 529 college savings plans, there’s no point to the strategy because your gains aren’t taxed.

Tax-loss harvesting is also most beneficial when you’re in a higher tax bracket. That’s because the higher your income, the more you are likely to pay in capital gains tax — and thus the more you stand to save by offsetting those gains.

If you’re planning to try tax-loss harvesting to balance gains in a certain year, keep in mind that you must sell the losing investments before the end of the calendar year.

Disclosure

This article is only for informational purposes. Robinhood does not provide tax advice. Please consult a tax professional.