Tax loss harvesting allows investors to use their investments that declined in value to reduce their annual tax bill. For long-term investors and active traders, this strategy can help create opportunities from investments that lost money.
But as with anything having to do with investing and taxes, tax loss harvesting is not simple.
What Is Tax Loss Harvesting?
The way tax loss harvesting—also known as tax loss selling—works is that an investor will sell off assets that have dropped in value as a way to offset the capital gains taxes they owe on the profits of investments that they’ve sold. Tax loss harvesting can even be used to offset as much as $3,000 in non-investment income. But to do so, an investor has to deduct their losses against capital gains first, before they can apply it to their ordinary income.
Another piece of good news is that losses beyond $3,000 can be rolled over to count against income taxes in the years to come. As such, the strategy can be the silver lining on investments that just didn’t work out.
Capital Gains and Tax Loss Harvesting
As far as the IRS is concerned, capital gains are either short-term or long-term:
• Short-term capital gains and losses are those made from the sale of an investment that an investor has held one year or less.
• Long-term capital gains and losses are ones recognized on investments sold after one year.
The IRS taxes short-term investments at the marginal income tax rate of the investor. For high-earners that can be as high as 37%, plus a 3.8% net investment income tax (NIIT). That means the taxes on those quick gains can be as high as 40.8%—and that’s before state and local taxes are factored in.
For long-term capital gains, on the other hand, lower capital-gains tax rates apply. For investors earning less than $78,750, it’s 0%. The tax rate rises to 15% if taxable income is $78,750 or more but less than $434,550 for single; $488,850 for married filing jointly or qualifying widow(er); $461,700 for head of household, or $244,425 for married filing separately.
(As with all tax laws, there is fine print. For instance, capital gains from sales of collectibles and fine art come with a 28% tax rate.)
The upshot is that investors selling off successful investments can face a stiff tax bill at the end of the year.
That’s typically when investors (or their advisors) start to look at what else is in their portfolios. Inevitably, there are likely to be a handful of other stocks, bonds, real estate or other different types of investments that didn’t come through for one reason or another.
The Silver Lining in Capital Losses
Those unsuccessful investments create something called a capital loss. While a capital loss technically happens whenever an asset loses value, it doesn’t exist in the eyes of the IRS until an investor sells the asset for less than the original purchase price.
The loss at the time of the sale can be used to count against any capital gains made in a calendar year. And, especially given the high taxes associated with certain capital gains, it’s a strategy that traditionally has many investors selling out of losing positions at the end of the year.
Rules of Tax Loss Harvesting
As with any investment strategy, it makes sense to think through a decision to sell just for the sake of the tax benefit. If an investor sells out of sinking stocks or other securities they still believe in, or that still play an important role in their overall financial plan, then they may find themselves in a bind. That’s because tax law prohibits them from receiving the benefit of the tax loss if they buy back the same investment too soon after selling it.
IRS rules state that investors can’t buy a security or another asset that’s “substantially identical” to the one they sold for 30 days. If they do buy something that’s identical, then they can’t claim the tax loss. But for an investment that’s seen losses, that 30-day moratorium could mean missing out on growth—and the possibility of buying it again later for a higher price.
When Should Investors Take a Tax Loss Harvest?
When an investor has a diversified portfolio, every year will likely bring investments that thrive and others that lose money. When it comes to tax loss harvesting, the decision is ultimately a personal one.
Tax Loss Harvesting When the Market is Down
For investors looking to invest when the market is down, capital losses can be easy to find. In those cases, some investors use tax loss harvesting to diminish the pain of losing money. But over long periods of time, the stock markets have generally gone up. The opportunity cost of selling out of depressed investments can turn out to be greater than the tax benefit.
It also bears remembering that many trades come with trading fees and other administrative costs, all of which should be factored in before selling stocks to improve one’s tax position at the end of the year.
Tax Loss Harvesting for Liquidity
There are years when investors need access to capital. It may be for the purchase of a dream home, to invest in a business, or because of unforeseen circumstances. When an investor wants to cash out of the markets, the benefits of tax loss harvesting can really shine.
In this instance, an investor is likely to face the largest capital-gains taxes, so it makes sense to be strategic about which investments—winners and losers—to sell by year’s end.
Tax Loss Harvesting to Rebalance a Portfolio
Nearly every long-term investor keeps a diversified portfolio. And to keep that portfolio properly diversified in line with their goals and risk tolerance, they’ll want to rebalance their portfolio on a regular basis.
That’s partly because different investments have different returns and losses over time. As a result, an investor may end up with, for example, more tech stocks and less energy stocks than they originally planned for, or more government bonds than small-cap stocks than intended.
Other possible reasons for rebalancing are if an investor’s goals change, or if they’re drawing closer to one of their long-term goals and want to take on less risk.
That’s why investors check their investments on a regular basis and do a tune-up, selling some stocks and buying others to stay in line with the original plan. This tune- up, or rebalancing, is an opportunity to do some tax loss harvesting.
Tax loss harvesting, or selling off underperforming stocks and then taking a tax credit for the loss, is helpful for investors in search of a silver lining on an investment that didn’t work out.
There are many reasons an investor might want to do some tax loss harvesting, including when the market is down, when they need liquidity, or when they are rebalancing their portfolio. It’s an individual decision, with many considerations for each investor—including what their ultimate financial goals might be.
With SoFi Invest®, members benefit from the best of automated investing technology and the automatic rebalancing of their portfolio as the market changes.
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