Everything To Know About Tax Loss Harvesting

Tax loss harvesting is the silver lining whenever a stock goes down. When you sell your investment for a loss, that loss can be deducted from your income and capital gains taxes.

Lowering your tax liability will indirectly increase your returns, especially if you have owned that investment for less than 1 year. Tax loss harvesting has some tricks, and we’ll walk through how to make the most of this situation.

What is Tax Loss Harvesting?

Imagine that earlier in any year you bought $100k worth of a stock or index fund. Later in the year, this same stock or index fund drops by 20% and is worth $80k. By selling the stock or index fund for a loss, you can offset that $20k from your taxable income. At 40% marginal income taxes, this move just reduced your tax exposure by $12k.

Anybody who knows basic numbers will call out a crucial flaw – that $12k tax benefit is a lot less than the $20k you lost.

But what if you reinvested the $80k you sold in a new investment? Doing so keeps you exposed at the same levels that you were before, but at a much lower cost basis.

Let’s say that your investment goes up to $120k. Had you just bought and hold, you would have a 20% gain for the year.

By harvesting the tax loss, you have a similar amount of wealth, and also reduced your tax exposure by $12k. Doing so allows you to realize a gain of 32% ($20k in appreciation and $12k in tax savings).

In this scenario, tax harvesting increased your gains by over 50%! Since stocks tend to go up more than they go down, it’s fair to assume the market will improve again, and pulling this move saved you a bunch in taxes.

Limitations of Tax Loss Harvesting

The IRS has limitations towards this maneuver. Their first is that the loss will be disallowed if you purchase the same or substantially similar investment after 30 days. This is known as the “wash-sale rule”.

To get around this, you need to make sure that your purchase after 30 days, or is not “substantially identical”. Selling Google and purchasing Baidu, for example, would not be substantially identical. While both are search engine companies, they operate in completely different markets.

Another example would be selling an S&P 500 ETF and purchasing a Russel 2000 ETF. Both ETFs hold similar companies, but they are not “substantially similar” since the Russel 2000 holds far more companies compared to the S&P 500.

Income Limits for Tax Losses

In our example, your $20k loss will result in a $12k tax break. Unfortunately, the IRS only allows you to deduct $3k of this loss from your taxable income every year, including dividends. The rest needs to be deducted from a similar gain or loss. In our example, you’ll have $9k that can be deducted from any additional short-term gains you had. If you only had $3k in short-term gains, the remaining $6k can be deducted from any long term gains as well.

If you still have unaccounted for losses, they can be deducted from future tax returns.

Tax Loss Harvesting – The Bottom Line

Tax loss harvesting is a great way to make lemonade from the lemons of losing money on an investment. By selling for a loss, you can deduct up to $3k per year from your annual income, and the savings can also be applied towards your short and long-term capital gains to reduce your tax exposure even further. Just make sure you don’t buy the same don’t buy the same stock within 30 days.

Any leftover amount can be carried forward to future tax returns if you max out the $3k limit and back out all of your capital gains.

Keep track of your investments, and make sure to make the most of this situation when it arises.