No one likes to think about tax season too soon, or else it puts a damper on the start of the year. However, investment returns aren’t immune to taxes—so if you’ve dipped your toes in the market in the past year, you may want to think about ways to minimize what you owe. One of these methods is called tax-loss harvesting (AKA tax-loss selling).
- Tax-loss harvesting, or tax-loss selling, means selling short-term investments at a loss.
- People practice this strategy to help offset short-term capital gains taxes.
- You can claim up to $3,000 in capital losses each year to help offset your profits.
- It’s only applicable to taxable investment accounts.
- The wash-sale rule prevents people from buying securities again within 30 days of the sale and harvesting the original losses for tax benefit.
- Tax-loss harvesting may marginally improve your overall investment returns, but the circumstances are particular.
- The best way to practice tax-loss selling is with the help of a trusted expert (not independently or automated).
Tax-loss harvesting, defined
At first glance, the term “tax-loss harvesting” seems like a trio of unrelated words put together. But if you think about it in context, it makes total sense.
Tax-loss harvesting is the practice of selling securities at a lower market value than your cost basis (AKA the price at which you bought them). In short, you’re choosing a particular position in your stock market portfolio that’s in the red, and selling it before you have the chance to profit.
You may be wondering, Why on Earth would I do such a thing?
Because of capital gains taxes.
How capital gains taxes tie into tax-loss harvesting
To understand the tax-loss selling tactic, you need a super quick briefing on how capital gains taxes work.
There are two types of capital gains: short-term (securities you held for a year or less before selling) and long-term (securities you held for more than a year before selling).
Long-term capital gains are taxed at a lower rate than your ordinary income. Depending on your salary, you could get a 0–20% tax for any profit you earn on the sale.
However, short-term gains are taxed at the same rate as your income, which ranges from 10–35% in 2020. Regardless of what you earn, that’s a hefty chunk out of your returns. No one likes the idea of giving Uncle Sam upwards of a third of their capital gains.
That’s exactly where tax-loss harvesting comes into play.
Just like you get taxed for your capital gains, you can get a tax write-off for your capital losses You can claim up to $3,000 of capital losses in 2020 (or $1,500 for those who are married but filing separately). This helps to offset any taxes you might incur from your gains.
Tax-loss harvesting is a strategy that many investment professionals use to offset capital gains taxes for their clients. If you’re an individual investor who’s earning a lot of profit in the stock market throughout the year, you’ll want to consider selling some securities while they’re still in the red to limit (or eliminate) how much you owe come tax season.
For big-time investors, $3,000 probably won’t be enough to offset taxes owed for short-term capital gains. However, those who are investing small to medium chunks of change for short-term investments are likely to notice a difference in their tax calculations.
Another way to make use of tax-loss selling
In addition to using tax-loss harvesting to offset your capital gains taxes, you can use it to offset ordinary (non-investment) income. Again, you can claim up to $3,000 of capital losses to offset an equal amount of income.
The nuances of tax-loss harvesting
It should come as no surprise that something involving the internal revenue service (IRS) is more complicated than it seems on the surface. Here are a couple of logistics that accompany the process (but keep in mind that there are many more).
Taxable investments only: Tax-loss selling is only applicable to taxable investment accounts. This means you can’t use the strategy for tax-advantages retirement accounts such as IRAs, 401(k)s and 403(b)s. You also can’t use it for other types of accounts in which taxes are deferred or forgiven, like 529 college savings plans, education savings accounts (ESAs), health savings accounts (HSAs) or flexible savings accounts (FSAs).
Wash-sale rule: The wash-sale rule comes straight from the IRS itself. It quells tax-losses in a specific way. The SEC defines a wash-sale as “when you sell or trade securities at a loss and within 30 days before or after the sale you buy substantially identical securities, acquire substantially identical securities in a fully taxable trade, [or] acquire a contract or option to buy substantially identical securities.”
Basically, this means you can’t sell at a loss just to repurchase the security all over again and expect to harvest those losses.
Does tax-loss selling actually help you make money in the stock market?
We know that tax-loss harvesting can help offset capital gains taxes in certain scenarios, but does it actually help increase your returns?
Some studies suggest that it can, but only marginally.
For example, a white paper from Betterment says the company’s automated tax-loss harvesting service earns the average investor an additional 0.77% return. Even this small percentage may be overstated, considering it’s based on the assumption that investors will automatically reinvest their savings. Anecdotally, we know this is not always the case.
Plus, the study is based on an equity-heavy portfolio, which is more likely to occur for long-term investments. Tax-loss harvesting is a strategy that correlates with short-term positions.
Another way to minimize capital gains taxes: holding long-term positions
As mentioned above, the IRS taxes long-term capital gains at a lower rate than ordinary income. In fact, people who file their taxes individually making up to $40,400 annually (or heads of the household making up to $54,100) aren’t taxed at all on their long-term positions.
Because of this, waiting just a little bit longer before selling could mean conserving the entirety of your returns.
The other two long-term capital gains tax rates are 15% and 20%, and only people filing individually who make more than $445,850 annually have to pay the full 20%.
To be clear, tax-loss harvesting is really only a complicated process when individuals try to do it manually. Many online brokerages offer automated tax-loss selling, but that’s not a preferred method, either. The best way to go about it is with the help of real experts, whether they be in the financial advisor’s office or behind a computer screen.
Many experts suggest that getting to gung-ho on tax-loss harvesting often means deferring taxes, not eliminating them. You may even be in a higher tax bracket down the road, in which case deferring is harmful.
Sylvia Kwan, chief investment officer at Ellevest, says, “The benefits of tax-loss harvesting depend on an investor’s goals, tax situation, whether or not she has capital gains to offset now and/or in the future, and the state of tax policy in the coming years.”