How Tax-Loss Harvesting Works for Retail Investors

Research-based tips for saving on your IRS tab

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Reviewed by Charles Potters

Losses in the market can prove profitable in many cases such as when you buy low to later sell high. It’s not just the losses of others that you can benefit from, however. Tax-loss harvesting is a strategy to help investors turn their reversal into an advantage. This technique was once primarily used by wealthy individuals and financial professionals. It’s now accessible to retail investors thanks to user-friendly investment platforms and robo-advisors.

Tax-loss harvesting involves selling investments that have dropped in value to offset capital gains taxes on other investments that have appreciated.

“Capital losses have a few benefits,” David Tenerelli, a certified financial planner at Strategic Financial Planning in Plano, Texas, told us. “They can be used to offset capital gains incurred during the same tax year as when the losses occurred, they can be carried forward to offset capital gains in future years, and they can offset up to $3,000 of ordinary income each year.”

Tenerelli said the strategy isn’t just about minimizing losses. It’s about strategically using them to improve your after-tax returns.

Tax-loss harvesting comes with its own set of rules, benefits, and potential pitfalls that must be navigated carefully, however. This is best done with some help. “The criteria for [what counts as] substantially identical securities is left purposefully vague by the IRS so investors should consult their financial advisor or tax professional if they’re unsure,” Tenerelli said.

Key Takeaways

• Tax-loss harvesting uses investment losses to offset capital gains or up to $3,000 of ordinary income, potentially cutting your tax bill significantly.
• This technique defers taxes rather than eliminating them because it lowers the cost basis of investments and this could lead to larger capital gains in the future.
• Losses can be carried forward indefinitely if they exceed the annual limit, providing flexibility for future tax planning.
• The strategy is now more accessible to retail investors because of shifts in financial technology and the rise of robo-advisors.
• Be mindful of the wash sale rule which prohibits repurchasing a “substantially identical” security within 30 days before and after selling at a loss.

What Is Tax-Loss Harvesting?

Tax-loss harvesting is a financial strategy that allows investors to use capital losses from selling losing investments to offset capital gains from profitable ones, potentially reducing their tax liability. The IRS permits the technique under specific conditions and it can be applied to stocks, bonds, exchange-traded funds (ETFs), and even cryptocurrencies.

Here’s how it works:

1. An investor sells an asset that has declined in value, realizing a capital loss.
2. This loss is then used to offset capital gains from other investments or up to $3,000 of ordinary income.
3. The investor can then reinvest the proceeds in a similar but not identical asset to maintain their desired market exposure.

You could use the loss to offset the gain and even deduct an additional $2,000 against your ordinary income subject to IRS limits if you sold Stock A at a $5,000 loss and have a $3,000 gain from selling Stock B,

Tax-loss harvesting doesn’t eliminate taxes. It defers them. Lowering the cost basis of investments can even lead to larger capital gains later when the new investments are eventually sold. The strategy is often worthwhile, however, because of the time value of money. A dollar saved on taxes today can be reinvested and potentially grow over time, Tenerelli said.

Tax-loss harvesting has traditionally been the province of wealthy individuals and their “tax loopholes” but it has increasingly become used by retail investors thanks to user-friendly investment platforms and robo-advisors.

Warning

Tax-loss harvesting can be worthwhile but it’s not suitable for all investors and it should be part of a combined investment and tax strategy. It’s best to seek the advice of a tax professional when engaging in this strategy given the legal complexities that can be involved.

How Tax Loss Harvesting Works

Tax-loss harvesting capitalizes on the balance between 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’s the difference between the cost basis or what you paid for an investment and the sale price. You have a capital loss not a capital gain if the cost basis is higher than the sale price.

The Tax-Loss Harvesting Process

Here’s a simplified view of the strategy:

1. Cultivate the tax savings: Review your portfolio for investments that have fallen in value since purchase.
2. Pruning the portfolio: You “realize” the loss by selling the asset. It can then be used for tax purposes.
3. Reap the benefits: The realized loss can offset capital gains from other investments. Up to $3,000 can be deducted against ordinary income if your losses exceed gains.
4. Sow the seeds for future gains: Reinvest the money from the sale into a similar but not identical asset.

When to Harvest

Tax-loss harvesting can be done at any time but many investors focus on it toward the end of the year when they have a clearer picture of their overall tax situation. Waiting until year’s end often means missing opportunities earlier in the year, however.

“Market corrections can be a great time to evaluate whether tax-loss harvesting opportunities exist in the taxable portion of the portfolio,” Tenerelli said. “By selling securities at a loss and then repurchasing similar (but not ‘substantially identical’) securities, the investor can gain a ‘tax asset’ (the capital losses) while keeping the portfolio properly allocated across asset classes, industries, sectors, and geographies.”

Market volatility can create windows for tax-loss harvesting earlier in the year that might not be available in December but some studies suggest there’s a reason tax harvesting is done later in the year. It’s often more profitable at that time with less uncertainty as to its purpose.

The Cost Basis

The cost basis is used to calculate the capital gain or loss when an asset is sold. Incorrectly calculating your cost basis can lead to over- or underreporting of gains or losses and potentially result in tax penalties.

Note

A capital loss isn’t considered realized for tax purposes until the investment has been sold for a price lower than the cost basis.

Short-Term vs. Long-Term Capital Gains

Short-term capital gains apply to assets that are held for one year or less. They’re taxed at your ordinary income tax rate which can be up to 37%. Long-term capital gains apply to assets held for more than a year. They’re taxed at lower rates: 0%, 15%, or 20% depending on your income bracket.

It’s generally more worthwhile to use short-term losses to offset short-term gains because of the higher tax rates.

Postponing But Not Eliminating Your Taxes

Tax-loss harvesting puts off rather than eliminates taxes. The new, lower-cost basis may also result in larger capital gains taxes in the future.

“While tax-loss harvesting does provide some tax benefits, the technique likely also resets their basis to a lower level, meaning that when they sell the replacement securities in the future, their capital gains may be higher than they otherwise would be,” Tenerelli explained. “However, tax loss harvesting is sort of a ‘tax arbitrage’ method in that the investor can benefit from the $3,000 annual ordinary income tax deduction while selling those appreciated replacement securities in the future at more favorable capital gains tax rates.”

The strategy is most worthwhile when you expect to be in a lower tax bracket in coming years, you plan to donate the securities to charity, or you plan to hold the securities until death, allowing your heirs to benefit from a stepped-up cost basis.

You can wait until April after the tax year to fund your IRA and take advantage of other tax deductions in many situations but that’s not the case with tax-loss harvesting. You must complete your sales by Dec. 31 or it can’t be used for that tax year. Many observe a sell-off of securities during the holiday period for this reason.

Annual Deduction Limits

You can use capital losses to offset an unlimited amount of capital gains. You can deduct up to $3,000 ($1,500 if you’re married and filing separately) from your ordinary income if your capital losses exceed your capital gains. Any unused capital losses can be carried forward indefinitely to future tax years.

Tenerelli added an important caveat: “There is no ‘bonus’ for investors who file their taxes jointly with their spouse—the $3,000 ordinary income tax deduction for capital losses is the same for single and joint filers.”

He noted, “Capital losses from selling publicly traded securities aren’t limited to offsetting capital gains from publicly traded securities but can also offset capital gains more generally, such as gains incurred when selling a real estate property or a business.”

Fees and the Cost in Time

You’ll want to consider brokerage fees and bid-ask spreads when executing trades for tax-loss harvesting. Keep good records of the cost basis and trading dates for proper tax reporting.

Many robo-advisors and some traditional brokerages now offer automated tax-loss harvesting which can cut down on the time and complexity involved.

The Wash Sale Rule

The IRS prohibits claiming a loss on a “wash sale,” selling a security at a loss and then repurchasing the same or a “substantially identical” security within 30 days of the sale. This rule applies across all accounts under your name, including IRAs and spousal accounts.

Consider investing in similar but not identical securities or waiting out the required period to repurchase to maintain your portfolio’s previous balance.

The wash sale rule takes account of all trades under the investor’s or the couple’s Social Security number(s). This means it applies to all their tax-deferred accounts, too. 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 60 days: 30 days before and 30 days after the sale. Spouses can’t use each other’s accounts to get around the wash sale rule if they file joint returns.

The vesting dates of stock bonuses and the purchase dates in employee stock purchase plans could also trigger violations of the wash sale rule.

Tax-Loss Harvesting Step-by-Step

1. Review your portfolio: Regularly assess your investments to identify positions with unrealized losses.
2. Calculate the potential tax savings: Estimate the tax impact of realizing losses against your capital gains and ordinary income.
3. Sell losing positions: Execute trades to realize losses considering your overall investment strategy.
4. Reinvest the proceeds: Immediately reinvest the proceeds in similar but not identical securities to maintain your portfolio allocation balance.
5. Observe the wash sale rule: Ensure you don’t repurchase the same or substantially identical security within 30 days before or after the sale.
6. Keep good records: Document all transactions including purchase dates, sale dates, and cost basis information.
7. Report the losses on your tax return: Properly report realized gains and losses on your annual tax return including Form 8949 and Schedule D.
8. Carry forward your excess losses: Carry them forward to future tax years if your losses are over the annual limit.
9. Consult professionals: Work with a financial advisor or tax professional to optimize your tax-loss harvesting strategy.
10. Review and adjust: Regularly reassess your strategy in light of changes in your finances, tax laws, and market conditions.

Important

Studies suggest that investors can expect about 0.9% to 5% more in returns from tax-loss harvesting. Those who aren’t in the upper tax brackets can expect extra returns closer to the lower end of that range.

Examples of Tax-Loss Harvesting

Comparing different scenarios can help illustrate this strategy’s potential benefits and considerations. The following table presents three situations: one without tax-loss harvesting, a simple tax-loss harvesting example, and a more complex case.

• Changed cost basis: Tax-loss harvesting can provide current tax benefits but it lowers the cost basis of your investments and this could lead to more significant capital gains taxes in the future.
• Complexity increases benefits and risks: This complex scenario shows how multiple loss harvesting opportunities can maximize tax savings but they also involve more transactions and the potential for error.
• Market recovery considerations: These scenarios don’t account for potential market recoveries. Being out of a position due to tax-loss harvesting could mean missing out on gains if markets rebound quickly.
• Individual circumstances matter: Your personal tax situation, investment goals, and risk tolerance all play a role in determining whether and how to implement tax-loss harvesting.

Best Situations for Tax-Loss Harvesting

Tax-loss harvesting can be a powerful strategy but it’s not suitable for every investor or situation. Here’s when it’s likely most worthwhile:

1. Investors in higher tax brackets: Those in higher income tax brackets tend to benefit more from the tax savings.
2. Investors with taxable investment accounts: Tax-loss harvesting only applies to taxable accounts, not to tax-advantaged accounts like individual retirement accounts (IRAs) or 401(k)s.
3. Active investors: Those who frequently buy and sell securities may have more opportunities for tax-loss harvesting.
4. Investors with diverse portfolios: A varied portfolio provides more opportunities to harvest losses without significantly altering overall strategy.
5. Long-term investors: Those with longer investment horizons can better leverage the benefits of tax deferral.

Important

Tax-loss harvesting should be tailored to individual tax and income profiles, said Tenerelli, the Dallas, Texas-based financial advisor. This is very similar to what investment advisors do when matching your asset allocation and risk profile to your objectives and time horizon.

When It Might Not Be Worthwhile

Tax-loss harvesting is generally less beneficial in the following circumstances:

• Your long-term capital gains rate may already be 0% if you’re in a low income tax bracket of 10% or 12%,
• You expect to be in a significantly higher tax bracket soon.
• Your investment strategy involves holding positions for the very long term with minimal trading.
• The administrative burden and potential costs outweigh the tax benefits for your situation.

What the Research Says

Tax-loss harvesting has been a topic of considerable interest in financial research with academics and industry experts seeking to understand its actual value and when it’s best done. Studies have looked to determine the best timing for harvesting losses to explore the broader economic impact of its use.

The research is often technical but the takeaways can be distilled into actionable guidance that can inform investment decisions and tax planning strategies. These are general findings open to revision and they’re not applicable in every situation.

There’s a “sweet spot” for when to harvest losses. Research suggests waiting to consider the move until an investment has dropped 10% for those reviewing monthly or 15% if you check daily. This balances the tax benefits against the risk of being out of the market because of the wash sale rule.

These “sweet spot” percentages work across different market conditions. The 10% and 15% thresholds are effective regardless of whether the market is volatile or stable.

It’s better to harvest large investment losses gradually, called “throttled harvesting.” Selling a significant position in your portfolio all at once for tax purposes can be risky. Researchers instead suggest selling portions over time.

• Large positions: These are investments that make up a substantial portion of your portfolio. It would be considered a large position if you have $100,000 invested total and $20,000 of that is in a single stock.
• The challenge: It could significantly change your portfolio’s overall composition and risk profile if this large investment has decreased in value and you want to sell it all at once for tax-loss harvesting. It could also shift the market for institutional and high-net-worth investors.
• The solution: Sell gradually over time instead of selling the entire position at once.

Researchers say this helps maintain your desired investment balance or allocation. This reduces the risk of being out of the market with much of your money.

Research suggests that these are the times when the strategy is most worthwhile:

• When your investments don’t all move in the same direction
• When you plan to sell your investments sooner rather than later
• When you expect your tax rate to be lower in the future

Other Options and Considerations

More sophisticated strategies can create large tax losses while still making money. Certain complex investment strategies can generate tax losses of over 100% of the amount initially invested while still providing positive returns before taxes, especially within two to three years.

Not selling is sometimes as important as selling to book your losses. Net capital losses in these strategies arise mainly from deferring capital gains, particularly short-term gains on long positions, rather than traditional loss harvesting. Many tax benefits come from holding onto investments that have gained value rather than just selling your losers.

Tax-aware long-short factor strategies can achieve high information ratios around 0.4 even after accounting for transaction and financing costs. An information ratio measures an investment manager’s skill or the effectiveness of an investment strategy by estimating how much extra return an investment strategy generates compared with a benchmark relative to the additional risk it’s taking on. It’s like the baseball statistic “wins above replacement.”

Important

An information ratio above 0.4 is generally considered good and above 0.6 is considered excellent. These strategies can provide good returns compared with their level of risk after accounting for all costs.

ETFs are popular for tax-loss harvesting. Studies have found that about 9% of the value and about a fifth of all volume in highly correlated ETFs traded each month is for tax-loss harvesting purposes. Highly correlated ETFs are those that track similar assets or indexes.

More sophisticated strategies boost returns still further. Advanced tax strategies can add an average of about 0.8% to annual returns over using simple tax-loss harvesting techniques. That’s on top of the likely gains with those traditional strategies that depend on different market situations.

Does Tax-Loss Harvesting Cancel Your Tax Obligation?

Tax-loss harvesting doesn’t permanently cancel your tax obligation on capital gains. It postpones taxes by lowering your current tax bill.

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

Short-term capital gains are realized on assets that are held for a year or less. They’re taxed as ordinary income. Long-term capital gains are realized on assets that are held for more than a year and they’re taxed at lower rates: 0%, 15%, or 20% depending on your income bracket.

Can I Use Tax-Loss Harvesting in My Retirement Accounts?

No, tax-loss harvesting applies only to taxable investment accounts. It can’t be used with tax-advantaged accounts like IRAs or 401(k)s because these accounts already have tax benefits.

The Bottom Line

Tax-loss harvesting is an accessible strategy that can help retail investors minimize their tax liabilities and potentially enhance their after-tax returns. Investors can offset capital gains and even reduce their ordinary income tax burden by strategically realizing losses.

Advances in financial technology have made this strategy more accessible to retail investors but it still requires careful consideration and planning. As Tenerelli noted, “The effectiveness of tax loss harvesting can change depending on future tax law changes.” It’s therefore important to stay informed about tax laws and regularly review your investment and tax strategies with a qualified professional.

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