Tax or capital gains harvesting can help you optimize your investment portfolio while shrinking your tax bill—a win-win for investors who want to reduce taxes and protect their assets. By countering capital gains with losses, you can strategize your way to significant tax savings and cut ties with underperforming investments, later reinvesting your tax savings to position your portfolio better.
What is tax harvesting?
Tax harvesting, also called tax-loss harvesting or capital gains harvesting, is a financial planning strategy investors use to reduce taxable capital gains. It involves selling underperforming investments at a loss—harvesting losses—to reduce capital gains taxes. Many investors reinvest the tax savings to replace the sold assets with similar investments over time.
This method can give lagging investments a new type of value. Instead of weakening your portfolio performance, they become the key to lowering your tax bill. Here’s how it works:
- Identify underperforming investments and sell them at a loss
- If capital losses are greater than your capital gains, deduct up to $3,000 ($1,500 if married filing separately) for the tax year
- Net losses over the limit may be carried forward to future tax returns
Tax-loss harvesting only works on taxable investments, and certain IRS rules impact how you can use this strategy to offset capital gains and replace struggling investments with new, similar investments.
What Are the Benefits of Tax or Capital Gains Harvesting?
Investors rely on this strategy because it can reduce tax liability and improve overall investment returns. Selling underperforming assets at a loss can offset all or part of your taxable capital gains to reduce or eliminate the tax you’ll pay. If your losses exceed the $3,000 limit, they can reduce your taxable gains on future tax returns.
By selling lagging investments, you can take the opportunity to rebalance your portfolio, cut ties with underperforming investments, and replace them after a certain period to improve your overall investment returns.
Identifying Losing Investments
Frequently reassess your portfolio to spot losing investments that could be sold at a loss—holdings with unrealized losses, those that no longer fit your portfolio goals or securities with the highest cost basis. Market downturns can be a prime time to sell, but it’s important to consider the opportunity cost if the market rebounds.
When is the best time to do tax-loss harvesting? Many investors harvest losses at the end of the year, but it’s a year-round strategy. Since it involves matching capital losses to gains in the same investment class, start thinking about harvesting before the end of the year—ideally when you rebalance your portfolio—to ensure you maintain the intended asset allocation.
What is the ‘wash sale’ rule in tax harvesting?
Reinvesting the tax savings from capital losses is key to maintaining balance and achieving your long-term portfolio goals, but be careful to avoid triggering the ‘wash sale’ rule.
What is the ‘wash sale’ rule in tax harvesting? This IRS rule disallows capital loss deductions if “substantially identical” securities are bought within 30 days before or after the sale. To avoid triggering the rule and losing out on tax savings, delay buying for at least 31 days before or after the sale or buy a different type of security to reinvest after the sale. A tax professional can help you ensure the new security is not considered substantially identical.
Tax Implications of Gains
Another consideration is whether your capital gains are short- or long-term. Offset gains of the same type first (short-term losses/gains vs. long-term losses/gains) to maximize tax benefits. Short-term gains (held for one year or less) are taxed at a higher rate than long-term gains. Offsetting short-term gains with short-term losses produces the biggest tax benefits.
The tax code requires short- and long-term losses to be used to offset gains of the same type first. Losses that exceed gains of the same type can then be applied to other gains.
Market Conditions and Capital Gains Harvesting
Market volatility becomes a tax-saving opportunity with harvesting strategies. Selling securities at a loss during market downturns is an advantageous way to reduce capital gains not only for the current tax year but potentially for years in the future. High-performing securities in bullish markets can make it challenging to sell at a loss, but consulting a MyStages® financial advisor can help you uncover opportunities in your portfolio with unrealized losses to benefit your tax bill.
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