How Tax-Loss Harvesting Works for Average Investors

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How Tax-Loss Harvesting Works for Average Investors

Tax-loss harvesting (TLH) is a strategy for lowering current taxes paid to the United States federal government by selling an investment at a loss (i.e., taking a capital loss) in order to use that loss to offset taxes owed on an investment sold at a profit (i.e., a capital gain) or even taxes owed on personal income. Any marketable asset (stocks, bonds, shares in an exchange-traded fund, or even cryptocurrency) may be used as an investment. Tax-loss harvesting is only applicable to taxable investment accounts, and the advantage is tax deferral rather than tax cancellation.

Although the Internal Revenue Service (IRS) allows the deduction of capital losses to offset taxes owed on capital gains, both advocates and critics of tax-loss harvesting agree that it is only appropriate for certain taxpayers in certain scenarios—and both agree that all taxpayers should consult an investment tax professional before attempting TLH.

Advocates position the technique as a hedge against market downturns—a shrewd way to turn a negative into a positive. Critics caution that executing tax-loss harvesting correctly requires expertise and that the strategy can easily backfire—even on investment professionals.

Key Takeaways

  • Tax-loss harvesting is a method for reducing current federal taxes by generating capital losses on purpose in order to offset taxes payable on capital gains—or even taxes owed on personal income.
  • Tax-loss harvesting merely delays, not cancels, tax payments.
  • If an investor does not have any capital gains to offset in the year in which the capital loss was “harvested,” the loss may be carried forward to offset future profits or income—there is no expiry date.
  • According to one research, tax-loss harvesting generated a broad range of results for small investors, with 40% of the variance caused by uncontrolled elements in the return environment and 60% influenced by individual variations in investor profiles.
  • Advocates pitch tax-loss harvesting as a savvy approach to transform a negative into a positive; detractors warn that tax-loss harvesting needs competence and that the practice may quickly backfire—even on investing experts.

Capital Losses to Offset Capital Gains and Personal Income

A capital gain (or a capital loss) is the difference between the cost basis—what a taxpayer paid for an investment—and the sale price—what they later earn when they sell it. 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.

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. (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 may capital losses be used to offset capital gains, but if losses exceed profits that year, the investor can utilize the leftover capital-loss balance to reduce personal income, or even carry the loss forward to offset gains in future years.

Although tax-loss harvesting may and should be done throughout the year, the most usual period is towards the end of the year, when yearly income taxes are due. Of course, the deadline for taking capital losses that will be used to offset capital gains for that year is December 31, which adds to the pressure. However, they warn that waiting until the end of the year for all TLH transactions may result in a capital loss that was possible in June no longer being accessible in December.

Tax-Loss Harvesting Only Postpones Tax Obligations

Tax-loss harvesting is only applicable to taxable investment accounts, and it is crucial to understand that the advantage of TLH is not the cancellation of the tax liability. The advantage is the same as with tax-deferred accounts: the tax liability is postponed. The logic behind tax-loss harvesting is that delaying current tax payments enables investors to utilize the savings to drive portfolio development in the present, with the premise that the dollar amount created over time will be much more than the final tax bill when it comes due.

The Lower the Cost Basis, the Higher the Tax Bill

Another significant factor to consider for investors is that, although tax-loss harvesting may decrease the tax payment owed this year, it also reduces the cost basis of the investment, which might result in a greater tax burden on future capital gains.

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A capital gain (or loss) is the difference between the cost basis (what a taxpayer spent for an investment) and the selling price (what they subsequently receive when they sell it), as defined above. When the cost basis falls, capital gains rise, as does the future tax burden.

Here’s an example of how tax losses may be used to decrease the cost basis:

  • An investor harvests a capital loss by selling an investment with a cost basis of $30,000 when the price drops to $25,000.
  • They may save $750 this year if they utilize the consequent capital loss of $5,000 (cost basis of $30,000 less selling price of $25,000) to offset the same amount of capital gains. (This assumes that their long-term capital gains tax rate is 15%: $5,000 x 15% = $750.)

In this case, tax-loss harvesting succeeded this year, but the $750 tax savings may not be durable in the long run, since harvesting the capital loss decreased the cost basis, as seen below:

  • The investor’s next natural move is to reinvest the $25,000 from the asset sold at a loss into a new security, which now has a reduced cost basis of $25,000 (down from $30,000).
  • If the value of the new investment rises to $30,000 by the time the portfolio is liquidated (sold for cash), the investor will have made a $5,000 capital gain (due to the lower cost basis of $25,000)—and the $750 tax savings this year will be lost on a future tax payment (assuming their tax rate stays the same).
  • However, if the value of the new investment rises over $30,000 to $35,000, the investor will have lost money—regardless of the increase in value. The reason for this is that the capital gains bill at liquidation will be calculated by subtracting the sale price of $35,000 from the lower cost basis of $25,000, resulting in a $10,000 capital gain that will be taxed at 15% for a total due of $1,500—twice the amount of taxes saved by harvesting the loss this year.
  • Of course, if the new investment falls even lower (rather than expanding), there are further prospects for tax-loss harvesting, but purchasing failing assets should never be the goal.

The danger for investors is that, between the time the capital loss is harvested and the tax bill is payable at portfolio liquidation, tax rates may vary, personal income can fluctuate, and the market can fluctuate—but taxes on capital gains will always be assessed on the investment’s cost basis. Because tax-loss harvesting automatically decreases the cost base, the method may provide no advantage or even result in a loss, as shown in the cases above.

Short-Term vs. Long-Term Tax Rates

When a capital gain or loss is achieved, the IRS categorizes it as either short-term (on assets held for less than a year) or long-term (on assets held for more than a year).The most essential short-term/long-term concerns for tax-loss harvesting are:

  • All tax-loss harvesting choices must take into account the fact that tax rates on short-term capital gains are substantially higher than on long-term capital gains.
  • Short-term capital gains are taxed as ordinary income at the marginal tax rate, which may range from 0% to 37% depending on your income category.
  • Long-term capital gains are taxed at a rate of 15% to 20% for most persons, depending on income.
  • For investors whose income tax rates are greater than their long-term capital gains tax rates, using capital losses to offset income rather than capital gains may make sense.
  • Capital gains are taxed at 0% for investors with income below specific thresholds—$40,400 for single filers and $80,800 for married couples filing jointly.

Allowances and Restrictions on Tax-Loss Harvesting

Here are some of the most notable tax-loss harvesting allowances and restrictions:

TLH Annual Restriction of $3,000: Tax-loss harvesting has an annual limit of $3,000, so an investor with a $5,000 capital loss may only utilize $3,000 this year (against either capital gains or personal income).The good news is that the remaining funds may be used to future tax returns.

Capital Losses Have No Expiration Date: In the example above, the investor can use their $5,000 capital loss to offset their entire $2,000 capital gain 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 profits to counterbalance that year, any capital losses harvested would roll over to subsequent years until required.

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Losses of the Same Type Must Be Used First to Offset Profits of the Same Type: Another essential point is that losses of the same type must be used first to offset gains of the same type. To counter short-term capital gains, short-term capital losses must be used first; long-term capital losses must be used first to offset long-term capital gains. Fortunately, if losses in one area outnumber gains in the same category, the leftover losses may be allocated to gains in the other. Of fact, because of the substantial disparity in tax rates, most investors will find that using short-term losses to balance short-term profits is the most beneficial strategy to employ tax-loss harvesting.

The Wash-Sale Rule

The wash-sale rule is the most complicated of the tax-loss harvesting regulations. This is how it works.

Most investors who employ tax-loss harvesting to reduce their taxes wish to keep their exposure to the industry in which they suffered capital losses. Although reinvesting after incurring capital losses is permitted, investors must be cautious not to breach the wash-sale rule, otherwise the IRS may deny capital gains offset. Here are the most essential concerns for investors who wish to keep involved while still being compliant:

To prevent investors from gaming the system in order 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 capital loss sale. This implies that for 30 days before and 30 days after the capital loss is recognized, investors must avoid from acquiring an identical or “substantially similar” asset, or even an option to purchase such securities.

Stock Bonuses and ESPPs: In addition to options, investors should be mindful that the vesting dates of stock bonuses or the purchase dates in employee stock purchase plans (ESPPs) may result in wash-sale breaches.

All Accounts Are Subject to the Wash-Sale Rule: It’s also worth noting that the wash-sale regulation applies to all transactions conducted under the investor’s or couple’s social security number(s), which means it also applies to all of their tax-deferred accounts. This implies that if an individual sells a stock in their brokerage account and then buys the identical stock in their IRA account during the 60-day waiting period, they will commit a wash-sale violation. Spouses filing jointly are not permitted to utilize each other’s accounts to avoid the wash-sale requirement.

Replacement Securities That Are IRS-Compliant: Financial experts warn that the IRS wash-sale regulation does not clearly define what constitutes a replacement asset that is “substantially similar” to the one sold to realize a capital loss. Due to the IRS’s limited advice, investors attempting to avoid wash-sale breaches must carefully examine the degree of overlap with the initial investment. Investors may keep exposure to the industry of the securities sold at a loss by investing in an exchange-traded fund (ETF) or mutual fund that targets the same sector during the 60-day timeframe but without breaking the wash-sale rule.

Sitting on the Bench Can Be Expensive: Many investors should reconsider trying tax-loss harvesting because of the wash-sale regulation, according to opponents. Markets may change dramatically in 60 days, and if an investor hasn’t identified an IRS-compliant substitute asset, the earnings they forfeit by waiting on the sidelines with inadequate participation in a hot area may be more than their TLH tax savings.

Although bitcoin exchanges must be recorded on tax returns as capital losses or capital gains, the IRS still considers cryptocurrency to be a property rather than a security (as of July 2022), therefore the wash-sale rule does not apply. In the cryptocurrency market, an investor may do precisely what the wash-sale rule for securities prohibits: sell cryptocurrency at a loss, purchase back the same cryptocurrency without waiting 60 days, and then use the capital loss to offset capital gains. However, when the United States Congress analyzes alternatives to regulate the crypto market in June 2022, the definition of cryptocurrencies as a property may change, according to the Wall Street Journal.

When Tax-Loss Harvesting Works

The logic for the tax delay is that a dollar now is worth more than a dollar tomorrow, particularly if the money saved on taxes this year is intelligently reinvested and produces more value than any future tax obligation at liquidation. When tax-loss harvesting works as expected, the reinvested tax savings may fuel portfolio growth even if the taxpayer makes no further contributions to the account.

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As previously said, both supporters and detractors agree that tax-loss harvesting is only suitable for certain taxpayers in particular situations. Anyone with a taxable investment account and taxable income over the tax code’s restrictions is eligible, as long as they have a somewhat lengthy investment horizon.

It is vital to realize that tax-loss harvesting does not permanently remove the need to pay taxes on capital gains—it merely delays it. Taxes on any capital gains are payable as soon as the taxable account is liquidated, and the tax rate in effect on the liquidation date applies.

Fintech Cuts Transaction and Administrative Costs

Costs are incurred whenever transactions are completed, including tax-loss harvesting trades: both transaction expenses (including fees and bid-ask spreads) and administrative costs (for trade execution and regulatory filings).For years, opponents of the broad adoption of tax-loss harvesting (TLH) have maintained that the TLH is only suited for bigger accounts (both institutional and individual), because these expenses represent a “lower percentage drag on the portfolio.”

According to a 2020 study conducted by the MIT Laboratory for Financial Engineering, recent advances in financial technology (fintech) and the overall decline in computing costs have lowered (or even eliminated) the transaction and administrative costs that often used to wipe out the benefits of TLH tax savings for small investors.

Now that fintech (particularly robo-advisors) has removed the cost barrier, the MIT analysts argue that tax-loss harvesting is feasible for both small and large accounts—and that fintech has the potential to drive TLH in the same way that it has fueled the growth of index funds and the options market.

When Tax-Loss Harvesting Doesn’t Work

Pro-TLH theories, critics claim, presume perfect circumstances for aspects that are very unpredictable in the actual world. Postponing tax payments, for example, works only provided tax rates (for both capital gains and individual taxpayers) stay constant (or fall)—and tax rates can never be foreseen, particularly throughout the lifespan of most investment portfolios. When tax-loss harvesting fails, the taxpayer may face a future tax payment substantially greater than any gains from reinvested tax savings.

Tax-loss harvesting opponents say that since small investors do not have the substantial, regular capital gains that make TLH lucrative for big investors, capital losses may accrue indefinitely without cutting taxes. In fact, according to a widely cited study published in the Financial Analysts Journal, 40% of what determines how profitable TLH is to small investors is determined by uncontrollable factors in the return environment, while the remaining 60% is determined by differences in individual investor profiles (income, tax rates, cash contributions/liquidations, percentage of income offset with losses).

As a result, the study’s experts recommended a case-by-case approach to tax-loss harvesting, particularly for typical investors. TLH should be adapted to individual tax and income profiles in the same way that investment advisers fit asset allocation and risk profile to each investor’s investment goals and time horizons.

Does Tax-Loss Harvesting Cancel Tax Obligations?

Tax-loss harvesting (TLH) does not remove tax liabilities; it only delays the tax payment, similar to how tax-deferred accounts do.

What Is the Point of Tax-Loss Harvesting?

Tax-loss harvesting, when done properly, helps investors to reduce their current tax payment, rebalance their portfolios, and retain more money invested.

What Is the Wash-Sale Rule?

The wash-sell rule is an IRS policy that forbids investors from utilizing a capital loss for tax-loss harvesting if the same asset, a “substantially similar” security, or an option on such a security is acquired within 60 days of the capital loss sale (30 days before and 30 days after the sale).

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

The most significant distinction is that the tax rate on short-term capital gains (assets held less than a year) is much greater than the tax rate on long-term capital gains (on assets held for more than a year).

What Is the Tax-Loss Harvesting Process?

The tax-loss harvesting procedure consists of three steps: 1) selling assets that have lost value; 2) utilizing the capital loss to offset capital gains on other sales; and 3) replacing the exiting investments with comparable (but not too similar) investments to preserve the desired investment exposure.

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