How To Lower Your Tax Bill With Tax-Loss Harvesting

Taxes might be your biggest expense in any given year. But if you’re a high-earner, you might benefit from tax-loss harvesting.

The idea is to sell investments that are currently down, capture any losses incurred, and write off those losses on your taxes.

But the process of tax-loss harvesting can be confusing — and if you don’t do it right, you may not get any tax benefits at all.

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What Is Tax-Loss Harvesting?

Tax-loss harvesting is the process of selling an investment in one of your taxable accounts for a loss and using that loss to offset any taxable gains from your investments during the same year. 

The IRS allows you to claim a capital loss on your tax return when you sell an investment(s). You can deduct this loss against any capital gains for the year, thereby lowering your tax bill.

But after selling your investment, you can purchase a similar investment that fits your investment strategy and chosen asset allocation — keeping you invested in the market. 

This strategy effectively locks in the loss on your previous investment and lowers your tax bill, but allows you to stay invested for the long term.

Tax-loss harvesting can only be done in taxable investment accounts — this strategy does not work in retirement accounts such as a 401(k) or IRA, or other tax-advantaged accounts such as a health savings account (HSA) or 529 account.

How Does Tax-Loss Harvesting Work?

Tax-loss harvesting is a strategy to lower your taxable income while keeping your investment accounts balanced. It is a three-part process:

1. Sell a losing investment in your taxable account

To claim a loss on your taxes and lower your tax bill, you first need to identify a losing investment in one of your taxable investment accounts. 

This could be a stock, bond, or other investment in your brokerage account that has underperformed.

You’ll choose how much of that investment to sell and execute the trade — locking in a loss on the investment in the form of a capital loss. 

Your broker should be able to supply the cost basis (how much you paid) and the capital loss for the investment. 

The loss is the difference between your cost basis and what you sold it for.

RELATED: What To Do When Your Stocks Are Losing Money

2. Purchase another investment

After you sell your investment(s) for a loss, you’ll want to pick another investment to put your funds in. 

While capturing the tax loss is important, you also want to stay invested for your long-term goals. 

Warning: Choose a replacement that isn’t identical to the investment you just sold. Otherwise, this could trigger a “wash sale” where the IRS does not recognize the loss and you cannot deduct the loss.

If you’re selling one stock to purchase another, this is a fine replacement and will enable you to write off losses. 

But if you pick two mutual funds with very similar holdings, this could trigger a wash sale — so it may be a good idea to meet with a CPA or financial advisor before performing tax-loss harvesting.

3. Claim the loss on your tax return

Once you’ve sold an investment at a loss in your taxable investment account, you’ll need to report the loss when you file your tax return with the IRS. 

You’ll report the capital loss on form 8949 from the IRS (or through your preferred tax software). 

You can claim up to $3,000 per year in capital losses against your income. If the loss incurred is larger than $3,000, you can carry forward the additional loss to claim in future years.

What Is the “Wash Sale” Rule?

The wash sale rule applies when you sell a particular investment for a loss and purchase one that the IRS considers “substantially similar” within 30 days. 

This completely cancels out the tax-loss harvesting strategy, since the IRS won’t let you claim the loss on your tax return.

For example, if you sell a Vanguard S&P 500 index fund and then purchase a Fidelity S&P 500 index fund within 30 days inside the same account, this would trigger a wash sale.

What To Consider Before Tax-Loss Harvesting

There are several considerations you should keep in mind if you want to apply tax-loss harvesting to your investment strategy.

It only works in taxable investment accounts

You can’t tax-loss harvest in tax-advantaged accounts, such as 401(k), IRA, HSA, or 529 accounts. 

If a majority of your investments are already in tax-protected accounts, then tax-loss harvesting may not be very beneficial.

It’s not very helpful if you’re in a low tax bracket

Before selling an investment to capture losses, it’s important to know your effective income tax rate. 

If you are in a lower tax bracket or have tax credits that minimize your tax bill, then tax-loss harvesting may be a lot of work for very little benefit.

RELATED: How Do Tax Deductions Work?

Don’t forget to reinvest the funds from your sale

While it can be tempting to cut your losses on an investment and just claim the loss on your tax return, you’d be missing out on one of the biggest benefits of tax-loss harvesting. 

Staying invested in the market allows your money a longer time frame to grow, and keeps you from spending the money on something that won’t grow in value.

Stay invested and put your cash from the sale back to work.

RELATED: How To Set Your Investment Goals

FAQs

Is tax-loss harvesting illegal?

Tax-loss harvesting is not illegal. It is simply selling an investment at a loss and purchasing another investment that helps you with your financial goals. 

This is a perfectly legal investing strategy that can help you save on taxes and invest more.

How much can you write off with tax-loss harvesting?

Tax-loss harvesting allows you to write off up to $3,000 in capital losses each year. 

If you sell an investment that captures a loss that is larger than $3,000, the extra losses carry forward indefinitely, and you can continue to write off $3,000 in losses each year until all the losses have been claimed.

TL;DR: Should You Use Tax-Loss Harvesting?

Tax-loss harvesting is when you sell an investment at a loss and reinvest the money elsewhere. It’s a legit way to reduce your tax bill while adjusting your investments for your long-term goals.

However, there are some important rules to follow, like not buying another investment that is “substantially similar.” And it may not be right for you if you’re already in a low tax bracket.

Speak with a financial advisor or CPA to decide if it’s right for your financial situation.

For more tips on managing your investments, check out these episodes of the Erika Taught Me podcast:

• How To Invest for Beginners (Step by Step)
• Money & Investing Pitfalls to Avoid
• Do THIS to Become a Millionaire

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