What is Tax-Loss Harvesting?

Robinhood Learn
Democratize finance for all. Our writers’ work has appeared in The Wall Street Journal, Forbes, the Chicago Tribune, Quartz, the San Francisco Chronicle, and more.
Definition:

Tax-loss harvesting is a strategy to help reduce your taxes by using your investment losses to offset investment gains or income.

🤔 Understanding tax-loss harvesting

Losing money on your investments isn’t fun, but you might be able to use the situation to your advantage. By selling investments that have experienced losses, you can potentially reduce or eliminate capital gains tax on those that have experienced gains. If you don’t have investment gains, you still might be able to use investment losses to decrease what you owe in federal income taxes, subtracting up to $3,000 a year from your taxable income. If you have more than $3,000 in net investment losses in a given year, you may carry over your losses to lower your taxes in future years. Tax-loss harvesting only applies to taxable accounts, not tax-advantaged retirement accounts (like 401ks and IRAs) or 529 college savings plans. It’s important to make sure you follow federal rules when trying tax-loss harvesting.

Example

Let’s say an investor named Layla buys 100 shares of Stock A at $5 per share and 100 shares of Stock B at $5 per share at the beginning of the year. Toward the end of the year, Stock A is trading at $6 a share, and Stock B is trading at $4 a share. Layla decides to sell Stock A, for a profit of $100. If Layala does nothing else, she’ll owe short-term capital gains tax on her profit. To offset her gain though, Layla decides to sell her shares in Stock B, for a loss of $100. Through tax-loss harvesting, Layla can offset her gains with her losses, and she may be able to avoid paying capital gains tax.

Takeaway

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.

Ready to start investing?
Sign up for Robinhood and get stock on us.Certain limitations apply

New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC.

Tell me more…

What’s the purpose of tax-loss harvesting?

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 before selling it:

  • 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 2020, the highest marginal rate was 37% for individuals with incomes above $518,400, or married couples filing jointly with incomes above $622,050.
  • Long-term capital gains apply to investments you owned for more than a year. These are taxed at between 0% and 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. Even if you had more investment losses than gains in a certain year, you may be able to use tax-loss harvesting to offset up to $3,000 in income as an individual or married couple filing jointly (or $1,500 as a married person filing separately).

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.

How does tax-loss harvesting work?

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, her net capital gains are $0, so she 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.

What is the wash sale rule?

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 want 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. You might also be able to 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.

What is cost basis?

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.

When should you use tax-loss harvesting?

Anyone who has investment losses can consider using tax-loss harvesting. Since you can 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.

Ready to start investing?
Sign up for Robinhood and get stock on us.Certain limitations apply

New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC.

20210428-1626009-4870535

You May Also Like

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

1771482

© 2022 Robinhood. All rights reserved.
Follow us on

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

1771482

© 2022 Robinhood. All rights reserved.