How Tax-Loss Harvesting Works for Average Investors

Tax-loss harvesting is a stock investing strategy that attempts to lower the taxes an investor will pay to the U.S. federal government during a current taxable year. Investors using tax-loss harvesting may choose to sell some securities at a loss, then use those losses to offset capital gains or other taxable income. This lowers the tax bill the investor pays in that year, allowing them to reinvest the money they earned back into their portfolio.

Tax-loss harvesting is not appropriate for all investors or all situations. However, advances in financial technology have made it more accessible for average investors with smaller, personal investment portfolios.

Key Takeaways

• Tax-loss harvesting involves using the losses from the sale of one investment to offset gains made from the sale of another investment, lowering the federal tax owed that year.
• Tax-loss harvesting only defers tax payments, it does not cancel them.
• If an investor has no capital gains to offset in the year the capital loss was “harvested,” the loss can be carried over to offset future gains or future income. There is no expiration date.
• Tax-loss harvesting is not appropriate for all investors, but it can be used effectively even by average investors with only personal investment porfolios.

What Is Tax-Loss Harvesting?

Tax-loss harvesting is a strategy that uses the capital losses from one investment to offset taxes owed on capital gains (profit) from another investment. It is permitted under Internal Revenue Service (IRS) rules, though certain conditions must be met. The investment can be any tradable security (stocks, bonds, shares in an exchange-traded fund) or even cryptocurrencies.

To use this strategy, investors must sell an asset at a loss. This loss can then be used to offset taxes owed on other income, whether from a capital gain or even personal income. This lowers the tax bill the investor owes for that year, allowing them to take the total profit they made from both sales and reinvest it in a similar asset to maintain a balanced investment portfolio. Tax-loss harvesting is relevant only for taxable investment accounts. The benefit is tax deferral, not tax cancellation.

The rationale for the tax postponement is that a dollar today is worth more than a dollar in the future—especially if the money saved on taxes this year is wisely reinvested and builds more wealth than the amount of any future tax bill at liquidation. When tax-loss harvesting works as planned, the reinvested tax savings can drive the growth of a portfolio, even if the taxpayer makes no further contributions to the account.

Tax-loss harvesting can be executed by anyone with a taxable investment account and taxable income over the limits set by the tax code, as long as they have a fairly long investment horizon. However, this doesn’t mean it is appropriate for all taxpayers in all circumstances. Tax-loss harvesting can be used as a hedge against market downturns, but using it correctly requires expertise that average investors may not have. To avoid tax pitfalls, all taxpayers should consult an investment tax professional before attempting tax-loss harvesting.

How Tax Loss Harvesting Works

Tax-loss harvesting uses the balance of capital losses and capital gains to minimize an investor’s tax burden.

A capital gain is the profit that an investor makes when selling an asset. It is the difference between the cost basis—what a taxpayer paid for an investment—and the sale price. If the cost basis was higher than the sale price, the investor experiences a capital loss, rather than a capital gain.

For example, as soon as an investor sells stock with a cost basis of $25,000 for $27,000, they have realized a capital gain of $2,000—and that gain is taxable in the year they sold the stock and took the profit. If the investor sells the same stock for $23,000, then they instead have a capital loss of $2,000.

This is where the IRS-approved strategy of tax-loss harvesting comes into play. The investor who realized a capital gain of $2,000 can deliberately sell one of their other investments at a loss to offset the gain on their tax return. For example, if the same investor had another stock that they bought for $30,000 and then sold for $25,000 when the price dropped, they can “harvest” that price difference of $5,000 as a capital loss.

Note

For tax purposes, a capital loss is not considered realized until the investment has been sold for a price lower than the cost basis.

Not only can capital losses offset capital gains, but if losses exceed gains that year, the investor could also use the remaining capital-loss balance to offset personal income (up to a limited amount). It may even be possible for the investor to carry the loss over to future years to offset future gains.

Although tax-loss harvesting can be done throughout the year, the most common time is year-end, when annual income taxes are looming. December 31 is the deadline to take the capital losses that will be used to offset capital gains for that year, so that adds to the urgency. However, according to advocates, the danger of waiting until year-end for all tax-loss harvesting trades is that a capital loss that was available to be harvested in June may no longer be available in December.

Who Should Use Tax-Loss Harvesting?

Tax-loss harvesting is not appropriate for every taxpayer and every scenario. As a strategy, it assumes ideal conditions for factors that can be highly unpredictable in the real world.

For example, postponing tax payments works only if tax rates (for both capital gains and the individual taxpayer) remain at the same level (or drop). But in the real world, tax rates can never be predicted, especially over the lifetime of most investment portfolios. When tax-loss harvesting backfires, the taxpayer could wind up with a future tax bill that is far higher than any profits from reinvested tax savings.

Average investors also may not have the large, frequent capital gains that make tax-loss harvesting profitable for large investors, so capital losses might just accumulate indefinitely without lowering taxes. A study originally published in the Financial Analysts Journal found that 40% of what determines how profitable tax-loss harvesting is to small investors is driven by uncontrollable factors in the return environment and the remaining 60% of the variation is driven by differences in individual investor profiles (income, tax rates, cash contributions/liquidations, percentage of income offset with losses).

For this reason, the analysts on this study advocated a case-by-case approach to tax-loss harvesting, especially for average investors.

Transaction Fees and Administrative Costs

Other developments in financial technology have made tax-loss harvesting more accessible and appropriate for average investors.

Whenever trades are executed—including tax-loss harvesting trades—costs hit the account: both transaction costs (for commissions and bid-ask spreads) and administrative costs (for trade execution and regulatory filings). This traditionally made tax-loss harvest more appropriate for larger accounts (both institutional and individual), where these costs are a smaller percentage of the total portfolio.

However, a 2020 study conducted by the MIT Laboratory for Financial Engineering looked at the impact of recent advances in financial technology (fintech). These new technologies, and the overall decline in computing costs, have lowered or even eliminated the transaction and administrative costs that used to wipe out the benefits of tax-loss harvesting for small investors.

Now that fintech (especially robo-advisors) has removed the cost barrier, the MIT analysts argued that tax-loss harvesting has become practical for small accounts as well as large investors. The study’s analysts also argued that fintech has the potential to make tax-loss harvesting a common strategy for average investors, the same way it stimulated the growth of index funds and the options market.

Important

Tax-loss harvesting should be tailored to individual tax and income profiles—exactly as investment advisors do when they match asset allocation and risk profile to each investor’s investment objectives and time horizons.

Important Considerations for Tax-Loss Harvesting

Tax-loss harvesting is a legal strategy that even average investors can use to decrease their tax bill, if they are strategic with their investments. However, there are important considerations to keep in mind that impact how you manage your capital gains and losses.

Short-Term vs. Long-Term Tax Rates

Whenever a capital gain or a capital loss is realized, it is classified by the IRS as either short-term (on assets held for less than a year) or long-term (on assets held for more than a year). From a tax-loss harvesting perspective, the most important short-term/long-term considerations are:

• All decisions about tax-loss harvesting must take into consideration that tax rates are much higher on short-term capital gains than on long-term capital gains.
• Short-term capital gains are taxed as ordinary income at the marginal tax rate, which can be up to 37%, depending on income bracket.
• For most individuals, long-term capital gains are taxed at a rate of 15% to 20%, depending on income.
• For investors with income tax rates higher than their long-term capital gains tax rates, it might make sense to use capital losses to offset income rather than capital gains.
• For investors with income below certain levels—$40,400 for single filers or $80,800 for married couples filing jointly—capital gains are taxed at 0%.

Delayed Tax Obligation

Tax-loss harvesting is relevant only for taxable investment accounts, and it doesn’t cancel the investor’s tax obligation. Instead, the benefit is the same one offered by tax-deferred accounts: the tax obligation is postponed.

The rationale behind tax-loss harvesting is that deferring current tax payments allows investors to use the savings to fuel portfolio growth in the present. The assumption is that the dollar amount generated over the years will be significantly more than the eventual tax bill when it comes due.

The Lower the Cost Basis, the Higher the Tax Bill

Another important consideration for investors is that although tax-loss harvesting can reduce the tax bill due this year, the process automatically lowers the cost basis of the investment. This could result in a higher tax bill on future capital gains.

As explained above, a capital gain (or a capital loss) is the difference between the what a taxpayer paid for an investment (the cost basis) what they later earn when the investment is sold (the sale price). When the cost basis goes down, capital gains go up, and so does the future tax bill.

For example, an investor might harvest a capital loss by selling an investment with a cost basis of $30,000 when the price drops to $25,000. Their capital loss is:

$30,000 – $25,000 = $5,000

If this was a long-term capital gain (meaning it was held for more than one year) and their income qualifies them for a 15% tax on capital gains, then the investor could lower this year’s tax bill by:

$5,000 x 15% = $750

In this example, tax-loss harvesting has worked this year, but that tax savings of $750 is not necessarily permanent over the long term. If the investor uses the $25,000 from the asset they sold to reinvest in a new security, then the new lower cost basis is $25,000, down from $30,000. If the value of the new investment increases to $30,000 by the time the portfolio is liquidated (sold for cash), the investor will have incurred a capital gain of:

$30,000 – $25,000 = $5,000

If their tax rate stays the same, the tax savings of $750 this year will be wiped out on a future tax bill.

However, if the value of the new investment increases above $30,000 to $35,000, then the investor will have lost money, despite the increase in value of the investment. The reason is that the capital gains bill at liquidation will be calculated by subtracting the sale price of $35,000 from the lower cost basis:

$35,000 – $25,000 = $10,000

If their tax rate is still 15%, then their tax bill will be:

$10,000 x 15% = $15,000

This ends up being double the loss they harvested this year. Of course, if the new investment drops even further (instead of increasing), there are additional opportunities for tax-loss harvesting, but buying losing investments should never be the objective.

The caution for investors is that, from the time the capital loss is harvested until the tax bill comes due at portfolio liquidation, tax rates can change, personal income can go up or down, and the market can fluctuate. Taxes on capital gains, however, will always be calculated on the cost basis of the investment. The fact that tax-loss harvesting automatically lowers the cost basis could make the strategy deliver no benefit—or even create a loss—as in the examples above.

Allowances and Restrictions on Tax-Loss Harvesting

There are a few important allowances and restrictions on tax-loss harvesting. Investors will need to keep these in mind in order to take advantage of this tax strategy.

Consult a tax and investment professional before using a tax-loss harvesting strategy. They may spot pitfalls or concerns that you miss, which can save you time, money, and possibly an IRS audit.

Annual Tax Deduction Limit

There is an annual limit of $3,000 on tax-loss harvesting for income tax deductions. A taxpayer may only deduct up to $3,000 ($1,500 if you are married and file a separate return) or your total net loss shown on Line 16 of your Form 1040, Schedule D. Any total net loss on line 16 that is not used in the current tax year may be carried forward.

No Expiration Date on Capital Losses

In the example above, the investor can use their capital loss of $5,000 dollar for dollar to offset their entire capital gain of $2,000 this year—and the remaining capital-loss balance of $3,000 can be carried over to offset future capital gains (or income) until it is used up—there is no expiration date. In fact, even if the investor had no gains to offset that year, any capital losses they decided to harvest would carry over to future years until they are needed.

Losses Must First Offset Gains of Same Type

Another important consideration is that losses of one type must be used first to offset gains of the same type. Short-term capital losses must be used first to offset short-term capital gains; long-term capital losses must be used first to offset long-term capital gains. Fortunately, if losses in one category exceed gains in the same category, then the remaining losses can be applied to gains in the other category. Of course, due to the large difference in tax rates, the most profitable way for most investors to apply tax-loss harvesting is to use short-term losses to offset short-term gains.

The Wash-Sale Rule

Of all the restrictions on tax-loss harvesting, the wash-sale rule requires the most planning. This is how it works.

Most investors who use tax-loss harvesting to lower their taxes want to maintain their level of exposure to the sector in which they took capital losses. Although reinvesting after realizing capital losses is allowed, investors must be careful not to violate the wash-sale rule—or the IRS will disallow the offset of capital gains.

Note

The wash-sale rule is cited by critics as a reason that many investors should think twice before attempting tax-loss harvesting. Markets can move a lot in 60 days, and if an investor hasn’t found an IRS-compliant replacement security, the profits they miss by sitting on the sidelines with insufficient investment in a hot sector could be greater than their tax savings from tax-loss harvesting.

Here are the most important considerations for investors who want to stay both invested and compliant with the IRS wash-sale rule.

60-Day Waiting Period

To prevent investors from gaming the system to get a tax break, the tax code prohibits investors from deducting capital losses on what the IRS calls “wash sales,” i.e., using a capital loss for tax-loss harvesting and then repurchasing the identical security (or a “substantially identical” security) within 60 days of the sale that generated the capital loss. This means that investors must refrain from purchasing an identical or “substantially identical” security—or even an option to buy such securities—for 30 days before and 30 days after the capital loss is realized.

Stock Bonuses and ESPPs

In addition to options, investors need to be aware that the vesting dates of stock bonuses or the purchase dates in employee stock purchase plans (ESPPs) could possibly trigger violations of the wash-sale rule.

Applies to All Accounts

It is also important to remember that the wash-sale rule applies to all trades under the investor’s or the couple’s social security number(s)—which means that it applies to all their tax-deferred accounts, too. This means that an investor will trigger a wash-sale violation if they sell a stock in their brokerage account and buy the same stock in their IRA account within the 60-day waiting period. For married couples filing jointly, spouses are not allowed to use each other’s accounts to get around the wash-sale rule.

The IRS wash-sale rule does not clearly define what would make a replacement security “substantially identical” to the one sold to harvest a capital loss. With limited guidance from the IRS, investors trying to avoid wash-sale violations always have to consider the degree of overlap with the original investment. To maintain exposure to the industry of the security sold at a loss without violating the wash-sale rule, one option is investing in an exchange-traded fund (ETF) or a mutual fund that targets the same sector.

Cryptocurrency

Although cryptocurrency trades must be reported on tax returns as capital losses or capital gains, the IRS still considers cryptocurrency a digital asset rather than a security. Because the wash-sale rule applied to securities, it doesn’t apply to cryptocurrency.

In the crypto market, an investor could do exactly what the wash-sale rule disallows for securities—sell cryptocurrency at a loss, buy back the same cryptocurrency without observing the 60-day waiting period, and then use the capital loss to offset capital gains. However, as the U.S. Congress considers options to regulate the crypto market, the classification of cryptocurrency as a property may be subject to change in the future.

Does Tax-Loss Harvesting Cancel Your Tax Obligation?

Tax-loss harvesting does not permanently cancel your tax obligation on capital gains. Instead, this strategy postpones the taxes you owe. Once the taxable account has been liquidated, taxes are due on any capital gains.

What Is the Point of Tax-Loss Harvesting?

If executed correctly, tax-loss harvesting allows investors to lower their current tax bill, rebalance their portfolios, and keep more money invested.

What Is the Wash-Sale Rule?

The wash-sale rule is an IRS regulation that prohibits investors from using a capital loss for tax-loss harvesting if the identical security, a “substantially identical” security, or an option on such a security has been purchased within 60 days of the sale that generated the capital loss (30 days before and 30 days after the sale).

What Is the Difference Between Short-Term and Long-Term Capital Gains?

Short-term capital gains are realized on assets that were held for less than a year. Long-term capital gains are realized on assets that were held for more than a year. These are subject to different tax rates. The long-term capital gains tax rate is lower than the ordinary income tax rate across tax brackets. Short-term capital gains are taxed as ordinary income.

What Is the Tax-Loss Harvesting Process?

The three steps in the tax-loss harvesting process are: 1) Sell securities that have lost value; 2) Use the capital loss to offset capital gains on other sales; 3) Replace the exited investments with similar (but not too similar) investments to maintain the desired investment exposure.

The Bottom Line

Tax loss harvesting is the strategic approach to making the most of capital losses. Due to tax treatment of gains and losses, taxpayers may find it favorable to time when they sell securities at a loss and how they net this activity against favorable investment gains. Advances in fintech have made this strategy more accessible to average investors with smaller portfolios.

Any investors making use of a tax-loss harvesting strategy must keep in mind wash-sale rules, which stipulate restrictions on benefits and treatments of selling a security and rebuying it within a specific window.

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