Kiss your poor investment goodbye and get a tax break for doing it – that’s the idea behind tax-loss harvesting. It can be a smart move to make if you’re holding on to an underperforming stock or fund and you’re looking offset gains realized from selling another one of your investments.
Here’s how to maximize your upside with tax-loss harvesting and what to watch out for so that you don’t run afoul of Internal Revenue Service (IRS) rules on the practice.
What is tax-loss harvesting?
Tax-loss harvesting is the process of writing off the losses on your investments in order to claim a tax deduction against your ordinary income. To claim a loss on your current year’s taxes, you’ll have to sell investments in taxable accounts before the calendar year ends, and then report the action when you file taxes for the year.
The IRS allows you to claim a net loss of up to $3,000 each year (for single filers and married filing jointly) from busted investments — and it’s usually a good idea to take full advantage. That $3,000 net loss could save you $720 in taxes at the 24 percent marginal tax bracket at the federal level and potentially further savings at the state level.
A write-off reduces any other capital gains you’ve earned during the tax year, and it’s important to note that the deduction is a “net” loss. For example, you can earn $5,000 on one investment and lose $8,000 on another, and you can still claim the maximum $3,000 deduction.
Even if you can’t claim the maximum $3,000 net loss, you can still reduce the value of your gains and save on taxes that way. So if you have a $4,000 gain and a $1,000 loss, you’d have net earnings of $3,000, saving you taxes on the additional thousand dollars that you wrote off.
And if your losses spill over that $3,000 maximum? The IRS lets you push those extra losses into future tax years. So if your investments perform well next year and you realize some capital gains at that time, you can use prior unused losses to offset those future gains.
Tax-loss harvesting is valuable only in taxable accounts, not special tax-advantaged accounts such as IRAs and 401(k)s, where capital gains aren’t taxed annually (or sometimes at all – in the case of the Roth IRA.)
And if you’re looking to reduce your tax bill, you have a number of other ways to do so.
How to use tax-loss harvesting
If you want to use tax-loss harvesting for maximum benefit, follow the steps below. It helps to be highly organized as the calendar year ends, so that you know exactly how much you need to sell to optimize the strategy.
1. Determine your goal
Are you looking only to offset your gains and achieve the maximum $3,000 net loss? Or are you looking to close out a losing position and not worried about fine-tuning your write-off?
- If it’s the former, you might want to stay invested in a currently losing position that otherwise has a strong future.
- If it’s the latter, you might not care about what you’ve earned this year.
If you’re not looking to fine-tune your write-off, then you can simply sell your losers or any investment you no longer believe in and move on. When it’s time to determine your taxes, you can sort out the gains and losses.
However, if you’re investing in a fund, it might make sense to realize a loss, book the tax benefit and then turn around and buy a fund tracking a similar area of the market. Done right, you avoid the wash-sale rule (more below), so you’ll get the tax benefit now and can still enjoy the potential investment gains.
2. Figure your gains and losses
However, if you’re looking to fine-tune your loss and remain maximally invested, then you’ll want to figure your realized gains for this year and whatever else you might sell by year-end. Then you can determine how much of a loss you’ll need to offset those gains.
For example, if you’ve realized gains of $10,000 so far this year and expect to realize another $1,000 by the end of the year, you can expect a total of $11,000 in capital gains. Let’s imagine that you’ve already realized losses of $5,000 so far from asset sales. You have a net gain of $6,000. So, if you want to max out your net loss for the year at $3,000, you could realize a further loss of $9,000. If you realize a greater loss, it can be written off only in future tax years.
Look at your brokerage statements and see which investments are showing a loss. To max out your taxable loss, you’ll need to find investments where you’ve lost at least $9,000. You can use any number of losing positions to get to this figure.
3. Make the transactions
Once you’ve figured how much you need to sell and which positions you’re going to sell, make the transactions in your brokerage account before the calendar year ends.
If you want to buy back into the position later after claiming a loss, be sure to wait at least 30 days to avoid the wash-sale rule.
Many robo-advisors will automate the process for you
Maximizing the tax break from your capital losses can require an extra level of effort, but it still makes a lot of sense for investors to do. But if you use a robo-advisor to manage your accounts – and robo-advisors offer many benefits at a surprisingly low cost – then you can usually get tax-loss harvesting for no additional fee.
Robo-advisors can turbocharge tax-loss harvesting, doing more than most human advisors would be able to do. For example, robo-advisors use an automated process for maximizing your tax savings, and they may be checking daily to see if they can realize a loss on any fund. Then the robo-advisor buys a different but similar fund that mimics the performance of the original, so you end up with a tax benefit but still own a fund that’s likely to perform as well.
That’s one of the major benefits of a robo-advisor, and many offer automatic rebalancing as part of the deal, too. Here are the top robo-advisors for your portfolio.
Three things to watch out for when harvesting a loss
Here are three things you’ll want to watch out for as you use this tax break.
1. Wash sales
Of course, the IRS has some restrictions in place to prevent you from gaming the rules on tax-loss harvesting. The most notable of these caveats is the “wash-sale rule,” which prevents you from claiming a taxable loss and then immediately rebuying the security. And it holds for your spouse, too – one can’t sell and claim the loss while the partner is buying in their own account.
Instead, if you want to report a loss on your taxes, then you (and your spouse) will have to avoid repurchasing the losing security for at least 30 days. If you do buy the security again within the 30 days, you must forgo the tax benefit. However, you won’t lose the tax benefit forever. When you do eventually sell the security again, you’ll be able to recover the tax benefit and write off the loss.
2. Long-term losses vs. short-term losses
The IRS insists that you offset like with like. That is, your long-term capital losses first offset long-term capital gains, while short-term losses first offset short-term gains. It’s an important distinction because capital gains are taxed based on how long you’ve owned the security. Only after you’ve summed up your results can you then offset short-term gains with long-term losses.
Long-term capital gains are taxed at special rates that can be lower than what you would otherwise pay for your ordinary income – 0, 15 and 20 percent, depending on your income. These rates apply to assets that you’ve held for more than one year.
Short-term capital gains are taxed at your ordinary income rate, which can run as high as 37 percent. These rates apply to assets that you’ve held for less than one year.
Brokerages will report your gains and losses to you and the IRS. However, their figures aren’t always right, especially in complicated tax situations, so it can be worthwhile to keep good records of your transactions.
3. Avoid selling just to get the tax break
It can be easy to sell an asset such as a stock only to get the tax break — a sure thing — while the future gain on the stock is anything but certain. That’s especially true since stocks can be quite volatile in the short term. But if you’re holding the stock for its long-term potential, not just for this tax year, you might reconsider whether it’s smart to sell for a capital loss.
Stocks are investments that tend to do well over long periods, and claiming a loss right now may mean you sell the stock just as it’s about to rebound. If there’s nothing fundamentally wrong about the investment, you might consider holding the investment rather than selling.
Is tax-loss harvesting worth it?
Tax-loss harvesting is a way to generate real tax savings today by realizing investment losses. The tax savings are a real, tangible benefit for those who go through the process, but there are times when realizing losses can be a mistake. For example, sometimes an investment can suffer a temporary loss on its way to outsized gains. There’s a fine line between realizing a loss because of an error in analysis and selling because you haven’t been patient enough.
Consider the long-term prospects for the investment and whether they’ve changed since you first purchased the asset. If you still see potential in the investment, you might be better off holding on.
Tax-loss harvesting gives you an opportunity to score a tax break on a poor investment, and it’s a good opportunity to offset other taxable gains, especially if you think the investment will never recover. Consider taking maximum advantage in order to lessen your tax burden in any year.
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Note: Bankrate’s Brian Baker contributed to an update of this story.