Tax-Loss Harvesting: Turning Investment Lemons Into Lemonade
Tax-loss harvesting is a year-round strategy where you sell investments to reduce capital gains taxes in your portfolio. Learn general guidelines and see examples of how it works.
Key Takeaways
Tax-loss harvesting can help you remain in control over your tax situation and potentially keep more money working for your future.
Current capital gains are not required, and buy-and-hold investors as well as those in retirement may benefit from loss harvesting.
While the strategy can be effective, there are several costly mistakes you should be aware of—including the wash-sale rule.
Sometimes, the markets hand us lemons. But even in an environment where both stocks and bonds are posting negative returns, there may be a sweet side for investors in the form of tax and portfolio benefits with tax-loss harvesting. The strategy can be a smart way to lower your tax liability while maintaining the appropriate investment mix in your portfolio.
Learn the ins and outs of tax-loss harvesting and the importance of using this strategy correctly. It’s always a good idea to consult a tax advisor for your particular situation, but being aware of general guidelines can help you take your lemons and make lemonade.
Let’s dig in.
How Tax-Loss Harvesting Could Reduce Your Taxes
Tax-loss harvesting is a year-round tax-mitigation strategy where you can sell investments to reduce current and future years’ capital gains taxes in your portfolio.
Here’s a hypothetical example of how it works. Let’s say Mary and Max bought two mutual funds years ago for $25,000 each.
Investment A | Investment B | |
Original Value | $25,000 | $25,000 |
Current Value | $15,000 | $30,000 |
Result if Sold | $10,000 loss | $5,000 taxable gain |
The $10,000 loss from Investment A could offset the $5,000 gain from Investment B, eliminating the taxable gain and reducing the loss to a $5,000 loss.
That means Mary and Max would owe no taxes on the gain and could use the remaining $5,000 loss to offset $3,000 of their ordinary income in the current tax year.
The remaining $2,000 loss can be carried forward to offset capital gains or ordinary income in future tax years.
Potential additional tax savings:
Assuming Mary and Max are in the highest tax bracket of 37%, the potential tax savings on the $5,000 gain from Investment B taxed at the current capital gains rate of 23.8% results in $1,190 in tax savings.
In addition, the current tax code allows joint, single and head-of-household filers to apply up to $3,000 a year in remaining capital losses (after offsetting gains) to reduce ordinary income (including income from dividends or interest).
As a result, Mary and Max (in the 37% marginal tax bracket) can deduct the remaining $3,000 loss from their current-year income and save an additional $1,110 in income taxes.
Who Can Benefit From Tax-Loss Harvesting?
You don’t need to trade every day to benefit from tax-loss harvesting. Investors pursuing buy-and-hold strategies with minimal trading, and even those in retirement, may find it valuable. And current capital gains are not required.
Who Can Benefit
Investors with capital gains, which can come from a variety of sources:
Rebalancing portfolios.
Reducing large positions.
Liquidating investments for income.
Receiving capital gains distributions from actively managed mutual funds.
Note: Flows into and out of mutual funds are transacted in cash. The manager often must sell portfolio securities to accommodate shareholder redemptions or to reallocate assets. These sales may create capital gains for all fund shareholders, not just the ones selling their shares. These gains are taxable for all fund shareholders if held within taxable accounts.
Investors with no current-year capital gains to report:
You can still harvest losses to lower your ordinary income by up to $3,000 per year ($1,500 if married and filing separately). Any excess losses above the yearly limits can be carried over for use in future years, without expiration.
Investments To Consider Selling
Individual stocks, bonds, mutual funds and exchange-traded funds (ETFs) are all potential candidates for tax-loss harvesting. Consider selling:
1. Investments that haven’t met your expectations.
Sometimes your initial reasons, or thesis, for holding an investment do not pan out. It can be tricky to sell because investors are susceptible to the "sunk-cost fallacy," which is the idea that because you’ve already incurred costs, you must stick with the investment until you “get your money back.” This can lead to holding on to losing positions for way too long. You can reframe your thinking by asking yourself, “If I didn’t own this, would I buy it today?” If the answer is no, this may be a good candidate to sell and put your money to better use.
2. Investments that have grown to become large, concentrated positions.
Letting your winners run too long can lead to a lopsided portfolio. This increases the risk that your fortunes rise and fall based on the performance of one security or asset class. Tax-loss harvesting can help you rebalance your portfolio. Suppose your portfolio has drifted to 75% equities and 25% bonds from its original target of 60% equities and 40% bonds. In that case, you could sell losing equity investments and buy bond investments until you’re back to your original target investment mix—putting you back on track while lowering your tax bill.
3. Investments that have similar exposure in a tax-efficient alternative.
Both ETFs and mutual funds are subject to taxes on the difference between market value and cost basis when they are sold. They also are subject to taxes on capital gains distributions and income incurred while shares are held. But generally, ETFs are more tax efficient than traditional mutual funds because an ETF is bought and sold from one investor to another on an exchange as an in-kind trade. That means ownership of the ETF changes hands without directly selling the underlying stocks or other securities. This type of transaction, along with the mechanics of how ETF shares are issued and redeemed, typically results in fewer capital gains. Thus, ETFs could keep a larger pool of assets invested compared to mutual funds—which may mean more money that potentially earns returns and benefits from the power of compounding.
Still, you need to consider if a replacement security would not be deemed substantially identical by the IRS to avoid violating the wash-sale rule (discussed below).
The type of capital loss may have an impact on the potential tax savings. For example, short-term capital losses, for assets held one year or less, may be considered more valuable than long-term capital losses. The reason is the short-term losses directly offset short-term capital gains, which may be taxed at ordinary income rates—currently up to 37%—and subject to a Medicare surtax of 3.8% rather than the preferred capital gains tax rates currently up to 20%, in addition to the Medicare surtax of 3.8%.
Avoid These Harvesting Pitfalls
While a tax-loss harvesting strategy can be effective, there are several costly mistakes you should be aware of, including:
Wash-Sale Rule
The IRS’ wash-sale rule is a tax rule that prohibits investors from creating “artificial losses” by selling securities at a loss and buying the same or a substantially identical security within 30 days before or after the sale (a total of 60 days).
If you violate this rule, the IRS will disallow the loss, and you’ll end up paying taxes on gains that you thought were offset. Although the losses may not be “lost forever” and added back to the basis of the new securities purchased, it may defeat the purpose of harvesting the loss. Some factors to consider when deciding on a replacement investment that would not violate the wash-sale rule would be the degree of holdings overlap and the difference in prospective returns.
Investments in Tax-Advantaged Accounts
Tax-loss harvesting can be a valuable strategy for taxable accounts, but it’s important to avoid harvesting losses in tax-advantaged accounts like individual retirement accounts (IRAs), 401(k)s and 529s. In addition, you should avoid buying replacement investments inside the tax-advantaged accounts.
If you bought back the same investment or a substantially identical one in an IRA account, for example, the tax loss is lost forever. Stick with taxable accounts when using tax-loss harvesting. In the same vein, avoid related-party rules, where one spouse sells a security at a loss and buys the same security back in a spouse’s taxable account.
Don’t Let Taxes Drive Your Investing Decisions
While taxes are an important consideration when investing, and we hear about tax-loss harvesting causing the "January effect" in markets each year, taxes should not be the sole driver of investment decisions. Avoid making rash investment decisions based solely on tax considerations, as this can lead to poor performance or cause your portfolio to become loaded with massive, embedded gains and an outsized tax bill down the road. Finally, you could stray from your investment plan.
When used wisely, tax-loss harvesting can be a powerful tool to remain in control over your tax situation and potentially keep more money working for your future.
Exchange Traded Funds (ETFs) are bought and sold through exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
Long- and short-term capital gains are taxed at different rates. Long-term gains may only be offset by longer-term losses. Likewise, short-term gains may only be offset by short-term losses.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.