Selling an investment at a loss seems counter-intuitive. The whole point of investing is to make money, after all.
However, as any investor with the slightest bit of experience will tell you, losses are inevitable from time to time.
Rather than being a complete drag on your investment returns, investment losses can actually save you money.
What is Tax Loss Harvesting?
Tax-loss harvesting is a way to generate economic value out of a financial loss.
Normally, when you sell a stock at a profit, you owe tax on that gain.
Depending on the length of time you’ve held the stock, you may owe either ordinary income tax or capital gains tax.
Tax laws allow you to offset capital gains with capital losses. This means that your losses can reduce the amount of tax you pay on your gains.
If your losses are large enough, you can eliminate your taxes altogether.
The art of tax-loss harvesting involves more than just selling investments at a loss.
In fact, most tax and financial experts suggest that you shouldn’t sell an investment solely for tax purposes.
With proper planning, you can harvest tax losses efficiently while still maintaining your desired asset allocation.
How Capital Gains and Losses Work
A capital gain is a profit on an investment. There are two categories of capital gains, realized and unrealized.
A capital gain is unrealized until you sell it, at which point it becomes realized.
For example, if you buy a stock at $50 per share and it goes up to $60 per share, you have a $10 per share unrealized gain. If you sell the stock at $60 per share, you have a realized capital gain of $10 per share.
The same is true for capital losses.
If you buy a stock for $50 per share and it trades down to $40 per share, you have a $10 per share unrealized capital loss. That loss becomes realized if you sell it.
For tax purposes, capital gains and losses are divided into short-term and long-term.
A short-term gain or loss involves a security you have held for one year or less. That gain or loss becomes long-term if you have held the security for longer than one year.
The distinction between short-term and long-term is critical for tax purposes.
Short-term capital gains are taxed as ordinary income. You’ll pay the same amount of tax on these gains as you would on your salary or wages.
For 2018, the top federal tax bracket is 37 percent. The highest state income tax bracket, in California, is 13.3 percent. This means that California taxpayers in the highest bracket pay over 50 percent in tax on their income, which includes short-term capital gains.
But wait, there’s more.
Jointly filing taxpayers with a modified adjusted gross income (MAGI) above $250,000 also face the net investment income tax (NIIT).
The NIIT is an additional 3.8 percent levy on investment income, from dividends and interest to capital gains, both short-term and long-term. The MAGI limit for single taxpayers is $200,000.
Long-term capital gains benefit from a special capital gains tax rate.
For 2018, the maximum long-term capital gains rate is 20 percent. This rate can drop as low as zero percent for lower-income taxpayers.
Here are the long-term capital gains rates for 2018, sorted by income level and taxpayer filing status:
Long-term capital gains tax rates (2018)
|Tax rate||Single filer||Joint filer||Head of household|
|0%||$0 to $38,600||$0 to $77,200||$0 to $51,700|
|15%||$38,601 to $425,800||$77,201 to $479,000||$51,701 to $452,400|
|20%||$425,801 and higher||$479,001 and higher||$452,401 and higher|
Bear in mind that the 3.8 percent NIIT applies to long-term capital gains as well, based on MAGI levels.
Offsetting Capital Gains With Losses
Your capital losses can offset your capital gains on a dollar-for-dollar basis.
For example, if you have $2,000 in capital gains and $2,000 in capital losses, your net capital gain will be zero. You won’t owe any capital gains tax, even though you generated $2,000 in capital gains.
The IRS process for matching gains with losses is a bit more involved.
1. Time it for the end of the year.
Investors often harvest tax losses near the end of the year, when the year-to-date capital gains picture becomes clearer.
If you harvest your losses too early, you may end up with taxable capital gains if you take another profit later in the year.
2. Separate gains & losses.
Divide your capital gains and losses into short-term and long-term.
3. Offset gains.
Next, offset your short-term gains with short-term losses, and your long-term gains with long-term losses.
Any net short-term gain is then taxed as income.
Any net long-term gain is taxed using the special capital gains tax rates.
If your net capital loss exceeds your net capital gain, you can use this excess to offset up to $3,000 of your ordinary income.
If you have net taxable income of $50,000, for example, and you end up with a net capital loss of $3,000, you can reduce your taxable income to $47,000.
Tax gains and losses only apply to regular, taxable investment accounts.
Automated Tax Harvesting
For many investors, keeping track of investment cost basis can be time-consuming at best, or tedious at worst. This is one area where robo-advisors can help.
A robo-advisor is an investment company that manages investor portfolios through the use of algorithms.
One of the benefits of robo-advisors is their ability to implement an automated tax harvesting strategy.
Tax-loss harvesting programs at robo-advisors like Betterment automate the entire process. At Betterment, an algorithm scours through portfolios regularly, looking for opportunities to harvest losses to offset capital gains.
Those losses are immediately reinvested into similar securities.
The net result is that portfolio allocations are maintained and taxes are minimized. Services like these at Betterment come at no additional cost to investors.
Robo-advisors that offer tax-loss harvesting are:
Carrying Over Tax Losses
One of the few bright spots in having a large amount of losses is the carryover provision.
If your realized capital losses exceed your realized capital gains, you can carry those losses forward indefinitely.
For example, if you have a $10,000 capital loss and only a $2,000 capital gain, you have $8,000 of losses you can carry forward. If you have a $3,000 capital gain the following year, you can offset that gain and still have $5,000 of losses to continue carrying forward.
Remember that before carrying over your losses, you can use up to $3,000 of a net capital loss to offset your ordinary income.
Avoiding Wash Sales
A so-called “wash sale” occurs if you sell a stock at a loss and then buy it back within 30 days.
For example, if you buy a stock for $10 per share, sell it for $8 per share and then immediately buy it back, you’ve triggered a wash sale.
A wash sale disallows the use of the loss as a tax deduction.
Further, you’ll have to add the amount of the loss to the cost basis of the stock you bought back.
In the above example, you could not claim the $2 loss per share as a tax loss.
Instead, you would have to add that $2 per share to the cost basis of your new shares.
For tax purposes going forward, it would be as if you paid $10 per share for your newly acquired shares, rather than $8.
Wash sales can be tricky to avoid because the IRS has a somewhat vague ruling on the subject.
According to the IRS, a wash sale is triggered even if you buy a “substantially identical” security within 30 days.
This means that you may still trigger a wash sale if you sell one S&P 500 fund at a loss and use that money to buy a different S&P 500 fund.
You’ll have to pay particularly close attention to wash sale rules if you are buying another security to replace the one you sold.
Robo-advisors can help you avoid wash sales through their active algorithm.
The bottom line with wash sales is that you have to be careful to avoid them. If your loss is disallowed, it means you’ve sold your security for no tax benefit at all.
The Bottom Line
All investors take losses at one point or another. Smart investors use these losses to reduce their taxes.
Most financial experts will suggest you don’t sell a stock at a loss simply for the tax benefit. But if the stock is one you are considering letting go anyway, use that loss strategically.
To keep your portfolio balanced, consider replacing it with a comparable substitute. Just be sure to steer clear of a wash sale violation.