Tax-loss harvesting is a strategic method used by investors to reduce taxable income and improve after-tax returns. By selling investments that have decreased in value, you can offset gains from other investments and potentially lower your overall tax liability. Here’s a detailed explanation of how it works and why it’s beneficial:
Step 1: Identify Underperforming Investments
The first step in tax-loss harvesting is reviewing your investment portfolio to identify assets that have lost value. These are often referred to as unrealized losses, meaning the loss exists on paper but has not been realized because the investment hasn’t been sold.
Step 2: Sell at a Loss
Once you’ve identified underperforming assets, selling them converts unrealized losses into realized losses. These losses can then be used to offset realized gains from other investments in your portfolio. For instance, if you have a $5,000 gain from the sale of one stock and a $3,000 loss from another, the loss reduces your taxable gain to $2,000.
Step 3: Offset Ordinary Income
If your losses exceed your gains in a given tax year, you can use up to $3,000 of the excess losses to offset ordinary income, such as wages or business income. For example, if you have $6,000 in realized losses and only $2,000 in realized gains, the remaining $4,000 loss can reduce your taxable income by $3,000, with $1,000 carried forward to future tax years.
Step 4: Carry Forward Remaining Losses
Any losses that remain after offsetting gains and ordinary income can be carried forward indefinitely. These carried-forward losses can be used in subsequent tax years to offset future gains or reduce taxable income, providing ongoing tax benefits.
Wash-Sale Rule
A critical consideration in tax-loss harvesting is the wash-sale rule. This IRS rule prohibits you from repurchasing the same or a substantially identical investment within 30 days before or after the sale that generated the loss. Violating this rule disqualifies the loss for tax purposes, so it’s essential to plan your trades carefully.
Benefits of Tax-Loss Harvesting
- Lower Tax Liability: By reducing your taxable income, you can lower the amount of taxes owed.
- Portfolio Rebalancing: Tax-loss harvesting provides an opportunity to realign your portfolio with your financial goals.
- Enhanced After-Tax Returns: By minimizing taxes, you retain more of your investment earnings.
Final Thoughts
Tax-loss harvesting can be a powerful tool, especially for investors in higher tax brackets. However, it requires careful planning and adherence to IRS rules. Consulting a financial advisor or tax professional can help you maximize the benefits of this strategy while avoiding potential pitfalls.
