What is tax loss harvesting?
E*TRADE, in collaboration with WisdomTree
How an investment loss can become a tax win
Did you know that a realized investment loss may help you improve your tax situation? It’s true. Through a strategy called tax loss harvesting, you may be able to use your losses to your advantage.
It’s a fairly simple idea. By selling the investment, you can realize or “harvest” the loss and use it to either offset your capital gains, reduce your taxable income, or maybe even improve your portfolio returns.
Using your loss to offset gains
Every time you sell an investment for more than you paid for it, you create a capital gain. This is a taxable event. Generally speaking, the amount of the tax will depend on your tax bracket, the type of investment, and how long you’ve held the investment.
And you may not realize it, but some investments can create capital gains even when you don’t sell them. These gains are generated by the manager’s trading or from the actions of other shareholders. When this happens, you might owe capital gains taxes on fund shares that you haven’t sold.
Capital gains overview
|Timeframe||Type of tax||Amount of tax|
|Asset held for less than a year||Short-term capital gains||10-37% (same as your income tax bracket)|
|Asset held for more than a year||Long-term captial gains||0%, 15% or 20% (depending on your taxable income and filing status)|
Taxpayers with adjusted income above the applicable threshold are subject to the 3.8% net investment income tax for their long-term capital gains and qualified dividends.
But what if you have something in your portfolio, like a stock or a fund, that has lost value during the year? If you realize the loss, the loss offsets your portfolio’s short- or long-term capital gains, which may lower the amount you will be taxed. And, of course, you have the option of rebalancing your portfolio with the cash generated from the sale.
How a loss can reduce ordinary taxable income
If your losses are more than enough to offset your capital gains, you may also be able to use them to reduce your ordinary taxable income by as much as $3,000. Let’s take a look at how that could work.
Imagine you invested $20,000 at the beginning of the year in security X. But toward the end of the year, security X is down by 10% and is worth $18,000. What can you do?
First, you could just hold on to the security. Second, you could sell the security, take the $2,000 loss, use the loss to reduce capital gains or deduct that loss from your ordinary taxable income, and reinvest the sales proceeds or use the proceeds for another purpose.
Here's a breakdown of the potential outcomes of these three options if you're in the 37% tax bracket and the 3.8% net investment income tax does not apply:
Hold, sell, or sell and reinvest?
|Option||Hold security X||Sell security X||Sell security X and buy security Z1|
|Potential tax savings||$0||$740 ($2,000 offset at 37% tax rate)||$740 ($2,000 offset at 37% tax rate)|
|Potential return||-10%||-6.3% (the loss is offset by the tax savings)||-6.3% (the loss is offset by the tax savings)|
|Market exposure||Position stays the same||None||Still invested in the market|
|Potential benefit||Can benefit if security X rises||Tax advantage||Tax advantage and can benefit if security Z rises|
1. Security Z should not be substantially identical to security X, as this would trigger a wash sale.
What is the wash sale rule?
With tax loss harvesting, there’s a key rule you should be aware of: the wash sale rule. This IRS law says you cannot buy an investment that is “substantially identical” to the one you’ve sold within 30 days of the sale or you risk losing the ability to claim the loss and any tax benefits that came with it. Therefore, it is important to understand this rule and how it may impact your reinvestment strategies before proceeding with a tax loss harvesting investing strategy.
The bottom line: Tax loss harvesting can be a potential strategy to help you manage your investment losses.