What is tax-loss harvesting, and how can it help your portfolio? Learn more about the rules and strategies, and see an example of tax-loss harvesting in action.
Should you consider tax-loss harvesting? It’s a process designed to take advantage of the IRS tax-loss harvesting rule that allows realized losses to offset the realized gains in your taxable portfolio. This process may potentially lower your tax liability—on the condition that all the trades are closed out in the same calendar year.
Sound complex? Let’s break it down.
As most investors know, the more positions you hold, and the longer you’ve been investing, the more likely you are to sustain a capital loss somewhere in your taxable portfolio. And at the same time, you might have realized taxable gains. But the IRS lets you match those gains and losses, and this can potentially lower your tax bill. Even if your losses exceed your gains, you can still claim capital losses—up to $3,000 per calendar year—until the entire amount of capital losses has been claimed.
At its core, tax-loss harvesting is the process of seeking out and culling losing positions to offset capital gains. This can be a manual process—as in the example below.
To illustrate the tax-loss harvesting strategy in its most basic form, consider two investors: Investor Allen and Investor Bea.
Investor Allen:
In this scenario, Investor Allen has a $1,000 profit on his ABCD trade, which will be subject to capital gains tax.
Investor Bea:
In this scenario, although Investor Bea has the same $1,000 profit as Investor Allen, because Investor Bea sold XYZ before the end of the year, the $1,000 loss on the stock is considered “realized” and may be used to offset ABCD’s gains—potentially eliminating capital gains tax.
If you don’t have any capital gains or if you have more losses than gains, you can use the losses to offset up to $3,000 of other taxable income per year. After using your losses to offset capital gains and income, you can use any remaining losses to offset gains or income in later years (under current tax laws).
Investors should educate themselves about the IRS’s wash sale rule, which prohibits them from claiming a tax loss if they open the same security position just recently closed (or a substantially similar security) either 30 days before or 30 days after closing a position for a loss. To evaluate whether you violated the wash sale rule, the IRS reviews the trading activity for all your accounts.
In other words, the IRS looks at trades you place in other accounts at TD Ameritrade, at other brokerage firms, and in IRAs or Roth IRAs, as well as transactions your spouse made and transactions by a business entity you control to determine if you violated the wash sale rule.
So a trade placed in one account may inadvertently create a wash sale in another account. You should be aware of investments in all of your investment accounts to determine if you run the risk of violating the wash sale rule.
There are a couple other potential advantages to tax-loss harvesting. First off, it can help minimize complexity. It’s a wealth management strategy that typically requires either the resources of a full-time advisor to manage or a significant amount of time spent by a client to effectively manage on their own.
Strategic tax-loss harvesting can help make your portfolio more efficient and potentially improve your after-tax returns. Just remember, as with any tax-related questions, you should talk to your tax professional, who can advise you on what’s appropriate for your specific tax situation.