Even in the best of times, not every investment will be a winner. Fortunately, losing investments do have a silver lining: You may be able to use them to lower your tax liability and better position your portfolio going forward. This strategy is called tax loss harvesting, and it’s one of the many tax smart strategies that investors should consider.
Tax loss harvesting generally works like this:
- Sell a security that is losing money.
- Use that loss to reduce your tax liability.
- Reinvest that money into a different security that meets your investment strategy.
The general principle behind tax loss harvesting is fairly straight forward, but it’s best to do some planning before implementing the strategy to make sure you avoid some common pitfalls.
Imagine you’re reviewing your portfolio and you see that your tech holdings have risen sharply, while some of your industrial stocks have dropped. As a result, you now have too much exposure to the tech sector. To bring your portfolio back in alignment with your preferred allocation, you sell some tech stocks and use those funds to rebalance your portfolio. In the process you recognize a significant taxable gain.
This is where tax loss harvesting comes in. If you also sell the industrial stocks that have declined in value, you could use those losses to offset the capital gains from selling the tech stocks, thereby reducing your tax liability.
In addition, if your losses are larger than the gains, you can use the remaining losses to offset up to $3,000 of your ordinary taxable income (for married persons filing separately, the limit is $1,500). Any leftover losses can be carried forward to future tax years and can be used to offset income down the road.
For example, let’s say you recognize a gain of $20,000 on some stock you bought less than a year ago (Investment A). Because you held the stock for less than a year, the gain is treated as a short term capital gain and taxed at the higher ordinary income rate rather than the lower long term capital gains rate, which applies to investments held for more than a year. At the same time, you also sell shares of another stock for a short term capital loss of $25,000 (Investment B). Your loss would offset the full $20,000 gain—you’d owe no taxes on the gain and the remaining $5,000 loss could be used to offset $3,000 of your ordinary income. The leftover $2,000 loss could also be carried forward to offset income in future tax years.
Assuming you’re subject to a 35% marginal tax rate, the overall tax benefit of harvesting those losses could be as much as $8,050. (In other words: $20,000 of offset capital gain + $3,000 current year deductible loss against ordinary income * 35% tax rate = $8,050 total savings).
Issues to consider
As with any tax related topic, there are rules and restrictions to be aware of before utilizing tax loss harvesting.
- Tax-loss harvesting isn’t useful in retirement accounts such as a 401(k) or IRA, because the losses generated in a tax-deferred account cannot be deducted.
- There are restrictions on using specific types of losses to offset certain gains. A long-term loss would first be applied to a long-term gain. A short-term loss would be applied to a short-term gain. If there are excess losses in one category, these can then be applied to gains of either type.
- When conducting these types of transactions, you should also be aware of wash sale rule, which states that if you sell a security at a loss and buy the same or a “substantially identical” security within 30 days before or after the sale, the loss is typically disallowed for current income tax purposes.
A tax break for ordinary income
Even if you don’t have capital gains to offset, tax-loss harvesting could still help you reduce your income tax liability.
Let’s say Sofia, a single income-tax filer, holds XYZ stock. She originally purchased XYZ for $10,000, but it’s now worth only $7,000. She could sell those holdings and take a $3,000 loss. Then she could use the proceeds to buy shares of ZZZ stock (a similar but not substantially identical stock) after determining that it is as good as or better than XYZ, given her overall investment goals and objectives.
Sofia could use the $3,000 capital loss to reduce her taxable income for the current year. If her combined marginal tax rate is 30%, she could receive a current income tax benefit of up to $900 ($3,000 × 30% = $900). She could then turn around invest her tax savings back in the market. Assuming an average annual return of 6%, reinvesting $900 each year would amount to approximately $35,000 after 20 years.
Harvesting losses regularly and proactively—when you rebalance your portfolio, for instance—can save you money over the long run, effectively boosting your after-tax return.
What you can do next
- Make sure that you’re considering the potential tax implications of your investments. Learn more about investment advice at Schwab.
- Talk to a financial professional. Find a Schwab Financial Consultant or visit a branch near you.
- If your tax situation is complicated, you may want to consult a tax professional.