Investing 101: How Tax Harvesting Works

tax harvesting

One of the biggest fears any investor has is losing money.

It’s a fact of life: Whenever you invest, you run the risk of losing your money. There is good news, though. If you do lose money in your taxable investment account, you can get a tax break for your loss.

It’s a strategy called tax harvesting, or tax loss harvesting, and you can use it to reduce your income and pay a little bit less on your taxes.

Offsetting capital gains

If you sell some investments for a gain, you’ll be taxed on your earnings. Luckily, the IRS allows you to offset capital gains using your capital losses.

One way to use tax harvesting is to offset what you’ve earned from your investments during the year. Look for your portfolio. Are there some assets that maybe aren’t doing so well? Do you hope to dump a loser and move on?

You can use all of your investment losses to offset your gains, dollar for dollar. You start by matching short-term gains with short-term losses, and long-term gains with long-term losses, but it’s possible to crossover.

Say you realized gains of $1,000 for a few short-term investments, and $2,000 in long-term investments. You decide to unload a losing long-term investment for $3,000.

You first offset the $2,000 in long-term gains, and with the remaining amount you can offset your short-term gains. Now, your investments are a wash and you don’t owe taxes on the gains. But what if you don’t have any capital gains to offset?

Tax deduction for investment losses

When my basement flooded a few years ago, I liquidated some of the investments in my emergency savings account to pay the associated costs. Unfortunately, the market was down at the time. I had to take a loss on the investments.

However, I was able to deduct those losses against my income using tax harvesting. The situation worked mainly to my advantage. I had the capital I needed to take care of the basement, and the costs associated with the flood ended up being tax-deductible.

When you don’t have capital gains to offset, you can deduct your loss from your income. For those filing single, the maximum annual deduction is $1,500. It’s $3,000 for joint filers.

It’s also possible to deduct excess losses from your income after you’ve offset your gains.

If you have gains of $3,000 for the year and losses of $4,000, you still have $1,000 left over. Use the first $3,000 of your losses to cancel out your capital gains, and deduct the remaining $1,000 from your regular income. This can further reduce your tax liability.

Even better, if you still have excess losses they can carry over to the next year. In the example above, if you had losses of $5,000, you’d have $2,000 left over after offsetting your gains. If you’re single, you can deduct $1,500 and still carry $500 over for a deduction the following year.

Watch out for the wash sale rule

One of the issues you need to watch out for when tax harvesting is the IRS wash sale rule. As an investor, it might be tempting to sell a losing stock at a low point, sell it, reap the tax deduction, and then buy it again while it’s still on sale.

That’s exactly the sort of situation the IRS wash sale rule is designed to prevent.

Basically, if you sell a losing asset, you can’t claim the loss on your taxes if you buy an investment that is substantially the same within 30 days.

Be careful of what you sell

It’s tempting to use tax harvesting on a regular basis once you understand how it works. However, it’s important to be careful about what you sell and when you sell it.

Generally, selling something just because it’s lost value in a market event is a bad idea. Before you sell, check to see if something has fundamentally changed about the asset. If the investment is still fundamentally sound, it’s probably a good idea to keep it for the long haul instead of selling it just for the tax deduction.

Tax harvesting is best used when you have an asset that is underperforming and you don’t think that it is a good bet for the future. It’s better to unload it and claim a benefit for the loss than to hold onto it as it goes even lower.

It can also make sense to use tax harvesting in accounts with a specific purpose. The accounts I have for emergencies and travel are good examples. I regularly add money to those accounts, and they are designed to provide me with capital when I want it.

When I’m ready to pay for a flooded basement or a weekend getaway, I liquidate the necessary shares, whether there’s a gain or a loss. It’s a pre-planned transaction selling broad-based index fund shares when I need them, rather than an emotional decision based on fear.

With the right approach, you can find the silver lining to investment losses. Just be sure that you consult with a tax-planning professional ahead of time.

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Published in Investing, Taxes