How Does Tax-Loss Harvesting Work?

Investors continuously seek strategies to maximize returns and minimize tax liabilities. If you’re wondering how to reduce taxable income for high earners, one popular solution is tax-loss harvesting. This technique involves selling securities at a loss to offset capital gains, thereby reducing overall taxable income.

But how does tax-loss harvesting work in practice, and what are the rules and implications? This article delves into these questions and explores the nuances of tax-loss harvesting.

What is tax-loss harvesting?

Tax-loss harvesting is a strategy used by investors to reduce their tax liability by selling securities that have declined in value, thus realizing a loss. This loss can then be used to offset capital gains from other investments. If losses exceed gains, up to $3,000 of the excess loss can be deducted against other types of income, such as wages. The primary goal is to optimize an investment portfolio for tax purposes without altering the overall investment strategy.

By realizing losses, investors can defer taxes and potentially invest the tax savings back into their portfolios, fostering growth. It is essential to understand that tax-loss harvesting doesn’t eliminate taxes; it defers them, ideally to a period when the investor may be in a lower tax bracket.

Tax-loss harvesting rules

Tax-loss harvesting is governed by several rules and regulations that investors must follow to benefit from this strategy effectively. Understanding these rules helps maximize the potential tax benefits.

Tax-loss harvesting limit

The IRS has set limits on how much loss can be used to offset other income. So, how much can you write off with tax-loss harvesting? While capital losses can offset an unlimited amount of capital gains, as of 2024, only up to $3,000 ($1,500 if married and filing separately) of net capital losses can be deducted against other income annually. Any excess losses can be carried forward to future tax years.

Tax-loss harvesting 30-day rule

The wash-sale rule is a critical tax-loss harvesting regulation. This rule states that if an investor sells a security at a loss, they cannot repurchase the same or a “substantially identical” security within 30 days before or after the sale. If they do, the loss is disallowed for tax purposes.

The intention behind the wash-sale rule is to prevent investors from selling a security to realize a tax benefit and then immediately buying it back, thereby maintaining the same position in their portfolio. To remain in compliance with this important rule, investors can purchase a similar but not identical security or wait until the 30-day period has passed to repurchase the original security.

Tax-loss harvesting carry forward

An important advantage of tax-loss harvesting is the ability to carry forward unused losses to future tax years. This means that if an investor’s losses exceed their gains and the annual deduction limit, the excess losses do not go to waste. Instead, they can be applied to offset future gains as well as up to $3,000 of other income each year until fully utilized.

For example, if an investor has $20,000 in capital losses and only $5,000 in gains, they can deduct $3,000 against other income and carry forward the remaining $12,000. This carryover can be particularly beneficial in years when capital gains are high, providing a significant tax shield.

Description	Amount
Realized Capital Losses	$20,000
Capital Gains	$5,000
Net Capital Loss	$15,000
– Used to Offset Other Income	– $3,000
Remaining Loss to Carry Forward	$12,000

Tax-loss harvesting: short-term vs long-term

Capital gains and losses are categorized as short-term or long-term, depending on how long the investment was held:

• Short-term gains and losses apply to assets held for one year or less
• Long-term gains and losses apply to assets held for more than one year

When harvesting losses, it’s essential to match the type of loss with the type of gain. Short-term losses should offset short-term gains first, and long-term losses should offset long-term gains. This is crucial because short-term gains are taxed at ordinary income tax rates, which are typically higher than the long-term capital gains tax rates.

Using short-term losses to offset short-term gains can therefore be more beneficial because of the higher tax rates applied to short-term gains. By following tax-loss harvesting best practices and carefully managing which losses are harvested, investors can optimize their tax outcomes. 

Other tax implications

It’s also important to consider other tax implications, such as the impact of unrealized gains and losses. Unrealized gains represent the increase in value of an asset that has not yet been sold, and thus, no tax is owed until the asset is sold. Conversely, unrealized losses can be a strategic element in tax-loss harvesting, as they offer potential future tax benefits.

Furthermore, investors should be aware of how tax-loss harvesting interacts with other tax strategies, such as writing off 529 contributions. Contributions to 529 plans are not deductible at the federal level, but some states offer tax benefits. Understanding these interactions can help you better create a holistic tax strategy that aims to maximize benefits across different aspects of an investor’s financial plan.

Is tax-loss harvesting worth it? Start a conversation with Avidian to learn more.

Tax-loss harvesting can be a powerful tool in an investor’s tax management strategy, but it’s not without complexities and risks. The effectiveness of tax-loss harvesting depends on individual circumstances, including the investor’s tax bracket, the composition of their portfolio, and their long-term financial goals.

Can a financial advisor help with taxes? Yes, and they should. Consulting with a professional financial advisor, like those at Avidian Wealth Solutions, can provide personalized insights and strategies tailored to your unique financial situation. They can also help to answer how tax-loss harvesting works regarding your unique portfolio.

Contact Avidian Wealth Solutions today to learn more about how tax-loss harvesting can fit into your comprehensive wealth management plan and how to navigate the intricacies of tax regulations to optimize your financial outcomes.

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