Investing is often seen as a simple win-or-lose scenario—either you make a profit, or you don’t. However, there’s a strategy that can help reduce the impact of investment losses: tax-loss harvesting. Let’s take a closer look at how it works and how it can benefit you.

What Is Tax-Loss Harvesting?

Tax-loss harvesting involves selling investments that have lost value in order to offset capital gains taxes on profitable investments. The idea is simple: by realizing losses, you can reduce your overall tax liability. These losses can offset capital gains from other parts of your portfolio, lowering the amount you owe in taxes.

In addition to offsetting gains, if your losses exceed your gains in a given year, you can use up to $3,000 of those losses to reduce your taxable income. Any loss greater than $3,000 can be carried forward to offset future gains.

Example of Tax-Loss Harvesting

Suppose you have a gain and a loss in your portfolio:

• Capital Gain: ABC Corp. Stock
  • Realized gain: $3,000
  • Potential tax liability: $600 (20% tax rate)
• Capital Loss: XYZ Corp. Stock
  • Realized loss: $10,000

By applying the $3,000 loss from XYZ Corp. to the $3,000 gain from ABC Corp., you eliminate the $600 tax liability. The remaining $7,000 loss can offset up to $3,000 of other taxable income in the current year, and the remaining $4,000 will carry forward to reduce future taxable gains.

How Does Tax-Loss Harvesting Affect My Portfolio’s Diversification?

Diversification is essential to managing risk and achieving long-term financial goals. When tax-loss harvesting, you’ll typically want to reinvest the proceeds from the sold assets into similar (but not identical) securities. This ensures that you maintain a balanced portfolio while still capturing the tax benefits of the loss.

For optimal results, it’s usually best to combine tax-loss harvesting with portfolio rebalancing, ensuring that your portfolio stays aligned with your risk tolerance and investment objectives.

When Is the Best Time to Harvest Losses?

While tax-loss harvesting is often done at year-end, when you can assess your entire tax situation, it’s also possible to harvest losses throughout the year. A market downturn might present an immediate opportunity to sell assets at a loss, freeing up cash to reinvest in undervalued securities. The timing of tax-loss harvesting depends on your unique financial situation and the market’s behavior.

Key Considerations and Pitfalls in Tax-Loss Harvesting

Though tax-loss harvesting is a straightforward concept, there are a few important rules and considerations to keep in mind:

1. Netting Rules: Short-term losses offset short-term gains first, while long-term losses offset long-term gains. If there are remaining losses after these offsets, they can be used to offset gains of the opposite type (short-term losses can offset long-term gains, and vice versa).
2. The Wash-Sale Rule: If you sell a security at a loss and buy the same or substantially identical security within 30 days, the IRS will disallow the loss. This is known as the wash-sale rule. Be mindful of when and how you purchase shares of the same security, especially if you’ve bought them in multiple transactions.
3. Diversification: When selling investments to realize tax losses, it’s important to maintain diversification within your taxable accounts, as well as across all your accounts, including tax-advantaged ones. This ensures your overall portfolio aligns with your long-term goals while optimizing tax efficiency.

Conclusion

Tax-loss harvesting can be a powerful tool to reduce your tax bill by offsetting capital gains. While the strategy is simple in theory, there are important rules to follow to ensure it’s executed correctly. Working with a financial advisor can help you navigate these rules, optimize your portfolio for tax efficiency, and make the most of tax-loss harvesting in your overall investment strategy.