Category: Tax Loss Harvesting

QUESTION:

What is tax-loss harvesting, and how is it used as a strategy by investors?

ANSWER:

Tax-loss harvesting is a strategy used by investors to reduce their taxable income by selling investments that have declined in value. By realizing losses, investors can offset capital gains from other investments, lowering their overall tax bill.

The losses can also be used to offset up to $3,000 of ordinary income annually, with any remaining losses carried forward to future years. This technique helps investors optimize after-tax returns, especially in volatile markets, by strategically managing their investment portfolios to minimize tax liabilities while maintaining their investment goals.

Nicholas owns a small tech startup and has invested in various stocks through his personal investment account. Over the past year, his portfolio included shares of Company A, which he bought at $10,000, and Company B, purchased at $8,000. Recently, Company A’s stock has declined to $6,000, and Company B’s stock has dropped to $5,000. Nicholas decides to implement tax-loss harvesting to reduce his tax liability.

He sells his shares of Company A at a loss of $4,000 and his shares of Company B at a loss of $3,000. These realized losses can offset his $7,000 capital gains from other investments or, if he has no gains, he can use up to $3,000 of the losses to reduce his ordinary income, carrying the remaining losses forward to future years.

By doing this, Nicholas effectively lowers his taxable income, saving money on taxes. To maintain his portfolio’s desired asset allocation, he then re-invests the proceeds into similar stocks or funds, avoiding the wash-sale rule. This strategic move helps Nicholas optimize his tax situation while keeping his investment strategy on track.

^{Client Profile is based on a hypothetical situation. The solutions discussed may or may not be appropriate for you.}

If investments you sold in 2024 lost money, you may find some solace in the IRS tax code. You can deduct certain losses from your taxable income — called tax-loss harvesting — when you understand the rules. Here they are briefly:

TERMS DEFINED

For starters, the IRS has separate tax rates for long-term investments — those which you have held for at least a year. The capital gains tax rate on net realized long-term investment gains, or capital gains, is 15% for most people.

You realize losses and gains only on investments you sell, not on those you still hold. Investments held for a year or less trigger ordinary income tax rates, which are typically higher. The IRS taxes some or all net capital gains at 0% if your income is low enough. You’ll pay 20% on net capital gains if your taxable ordinary income exceeds $518,900 if filing as a single, $583,750 if filing jointly, $551,350 if filing as head of household, and $291,850 if married and filing separately.

THE CALCULATION

To figure net losses, subtract what you realized from selling your investment from the original amount invested and then deduct any sales charges. If your realized capital losses are greater than realized capital gains, deduct up to $3,000 a year for individuals and married filing jointly or up to $1,500 if married and filing a separate return. You may carry forward any losses over this annual cap to future years.

LONG-TERM VIEW

Don’t sell investments just for tax reasons. Keep those that lost money last year if they continue to have long-term prospects and sell winners if they don’t fit your investment strategy.