Tax-Loss Harvesting: Lower Your Taxes

Tax-loss harvesting is a strategy that can significantly reduce your capital gains tax. By selling investments at a loss, you offset the gains you’ve made on other assets, potentially lowering your tax liability. While this approach can be highly beneficial, understanding its mechanics and the rules involved is key to effectively leveraging it.

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December 26, 2024

What is Tax-Loss Harvesting?

Tax-loss harvesting is a strategy investors use to reduce taxable gains. It works by selling investments at a loss and replacing them with similar investments to offset the gains made on other assets, thereby lowering the capital gains tax you owe. Additionally, the strategy can help reduce taxes on ordinary income.

The Two Types of Investments

There are two types of investments to consider when engaging in tax-loss harvesting:

Short-term investments: Held for a year or less, taxed at ordinary income rates (10%, 12%, 22%, etc.).
Long-term investments: Held for more than a year, taxed at reduced rates (0%, 15%, or 20%, depending on your income).

Rules for Deducting Capital Losses

Capital losses must first offset the same type of capital gains—short-term losses offset short-term gains, and long-term losses offset long-term gains. After this, any remaining losses can be applied to the opposite type of gain. You can deduct up to $3,000 ($1,500 if married filing separately) of net capital losses against ordinary income, and any excess losses can be carried forward to future years.

Who Can Benefit from Tax-Loss Harvesting?

The strategy is most beneficial for investors in higher tax brackets, particularly those with a portfolio that includes underperforming assets. Additionally, those with significant short-term capital gains can see substantial tax savings since short-term gains are taxed at higher rates than long-term gains. Tax-loss harvesting may also reduce the impact of the Net Investment Income Tax (NIIT).

However, tax-loss harvesting does not apply to tax-advantaged accounts like 401(k)s or IRAs, as gains in these accounts are not taxable.

Example of a Tax-Loss Harvesting Scenario

Let’s say an investor has $25,000 in short-term capital losses and $15,000 in short-term capital gains. In this case, the $15,000 loss can offset the $25,000 gain. The remaining $10,000 in losses can be used to offset $3,000 of the current year’s ordinary income, and the remaining $7,000 can be carried forward to offset future gains or income.

In this example, the tax savings calculation is as follows:

Capital gains tax: $15,000 x 35% = $5,250
Ordinary income tax: $3,000 x 35% = $1,050

Total tax savings from tax-loss harvesting: $6,300

Be Aware of the Wash-Sale Rule

While tax-loss harvesting can substantially reduce your taxes, remember the wash-sale rule. The wash-sale rule prevents you from claiming a loss on a security sale if you purchase a similar or identical asset within 30 days before or after the sale. To avoid violating this rule, it’s best to buy a different asset rather than a similar one. Additionally, cryptocurrencies are currently exempt from the wash-sale rule, though future legislation may change this.

Is Tax-Loss Harvesting for Me?

Before using tax-loss harvesting, consider your tax situation and whether incurring a loss is financially feasible. While tax savings can be substantial, selling an asset at a loss purely for tax purposes might not be the best move if it doesn’t align with your overall financial goals. A tax professional like DuPage Tax Solutions can help you navigate the tax implications of this process.

References

Topic No. 409 Capital Gains and Losses | Internal Revenue Service. https://www.irs.gov/taxtopics/tc409.