Investment gains are taxable. The tax you pay can be pretty significant depending on your tax rate. Tax-loss harvesting can lower your investment income and the associated tax burden.
However, it comes with rules and limits. Here’s what you need to know.
Learn more: Taxes on stocks: The rules and rates
Tax-loss harvesting is when you incur or harvest losses to offset your gains for advantageous tax purposes. You have a gain if you sell an asset for more than you paid for it. You have a loss if the transaction costs are more than the earnings. Because profits are subject to a capital gains tax rate, harvesting capital losses can lower your tax liability.
You might choose to sell an investment at a loss as part of an asset allocation strategy, better aligning your portfolio with your investment objectives. The amount of your realized loss depends on the cost basis, which is how much you paid for the asset.
Here’s an example:
You own 100 shares of Company A with a cost basis of $100 per share. If the price of these shares falls to $20 per share and you sell all your shares, your earnings are $2,000 (100 shares x $20), while your cost basis is $10,000 (100 shares x $100). You’d have a capital loss of $10,000 – $2,000, or $8,000.
If you had $9,000 in realized gains from other investments for the tax year, your $8,000 loss would reduce your tax bill. Instead of paying a capital gains tax on $9,000, you’ll be taxed on your net capital gain of $1,000 ($9,000 capital gain – $8,000 capital loss).
Short-term vs. long-term gains and losses
A capital gain or loss can be short term or long term. Whether you have short- or long-term gains can significantly impact your tax rate.
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Short-term capital gains: Profits from selling an asset you held for a year or less are taxed as ordinary income. Your income tax rate could be 10% to 37% (for 2024), depending on your tax bracket.
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Long-term capital gains: If you hold your investment for over a year, you qualify for the long-term capital gains tax of 0%, 15%, or 20%, depending on your income and tax filing status.
You’ll use short-term losses to lower short-term gains before tapping into your long-term investment losses.
While tax-loss harvesting can be an effective investment strategy, it comes with tax laws. Consider working with a tax professional and financial advisor to make sure you’re making the best investment decisions.
You can only use the tax-loss harvesting strategy for taxable accounts like a brokerage account where you own stocks, mutual funds, and ETFs. Tax-advantaged accounts, like a 401(k) or IRA, do not qualify since these retirement savings accounts come with different contribution and withdrawal rules.
If you have more losses than gains, you have a net capital loss that can lower your tax bill. Taxpayers can deduct excess losses from their taxable income up to a $3,000 limit (or $1,500 if married filing separately). Any loss above the capital loss deduction limit can roll over, pushing the tax savings into later years.
For example, if you have $8,000 in capital loss and $2,000 in capital gains, you have a net capital loss of $6,000 ($8,000 loss – $2,000 gains). You can use up to $3,000 to lower your taxable income in the current tax year. That leaves $3,000 in capital losses you can save for future tax returns.
Under the wash-sale rule, you cannot sell an investment at a loss for the tax benefit and then buy back the same or a similar investment within 30 days before or after the sale. That’s known as a wash sale, and the IRS does not allow you to deduct that loss. Instead of lowering your tax bill, a loss from a wash sale is added to your investment’s cost basis.
For example, on June 1, you incur a capital loss of $8,000 from selling 100 shares of Company A for $20 per share. If, on June 25, you decide to buy back your 100 shares of Company A, now valued at $10 per share, you can no longer deduct your $8,000 loss in the current tax year.
Instead, your shares will have a new cost basis of $10 + $80, or $90 per share. This includes the $10 you paid for the stock on June 25 plus the $80 per share loss you incurred on the sale on June 1 ($8,000 / 100).
Tax-loss harvesting can provide a significant tax benefit, particularly if you have short-term gains, which are taxed as income. Depending on your tax bracket, the tax on short-term gains can be well over the 20% maximum rate allotted to long-term gains. You can pay a lower tax by selling some investments at a loss, lowering your net investment income. Consider enlisting the help of a financial and tax advisor to see if this strategy makes sense for your situation.
Your capital losses can offset the full amount of your capital gains. However, if you have more losses than gains, you may be able to write off up to $3,000 of the excess loss to lower your taxable income. Any amount over the $3,000 net loss limit can carry over into future years.
If you sell an investment at a loss and then buy the same or a similar asset within 30 days before or after the sale, this is known as a wash sale and is not tax deductible. For example, if you sell a stock for a loss on June 1, you’ll need to avoid having bought a similar investment on or after May 2 and avoid buying a similar investment until after July 1.
