Tax Gain/Loss Harvesting

What is 'Tax Gain/Loss Harvesting'

Tax gain/loss harvesting is a strategy of selling securities at a loss to offset a capital gains tax liability. It is typically used to limit the recognition of short-term capital gains, which are normally taxed at higher federal income tax rates than long-term capital gains, though it is also used for long-term capital gains.

BREAKING DOWN 'Tax Gain/Loss Harvesting'

Tax gain/loss harvesting is also known as "tax-loss selling." Usually, this strategy is implemented near the end of the calendar year but may be completed at anytime throughout a given tax year. With tax-loss harvesting, an investment that has an unrealized loss is sold, thus realizing the loss, allowing it to be credited against any realized gains that occurred in the portfolio. The asset sold is then replaced with a very similar asset to maintain the portfolio's asset allocation and expected risk and return levels.

For many investors, tax gain/loss harvesting is the single most important tool for reducing taxes now and in the future. If properly applied, it can save you taxes and help you diversify your portfolio in ways you may not have considered. Although it cannot restore your losses, it can certainly soften the blow. For example, a loss in the value of Security A could be sold to offset the increase in value of Security B, thus eliminating the capital gains tax liability of Security B.

Tax-Loss Harvesting Example

Assume an investor is in the highest marginal tax rate bracket, which as of 2016 is 39.6%. Investments held for over 365 days and sold have their capital gains taxed at the long-term capital gains rate, which for an investor in this marginal tax rate bracket is 20%. Investments held for less than 365 days and sold have their capital gains taxed at the short-term capital gains rate, which is the tax rate of the investor's ordinary income. In this example, that rate is 39.6%. Assume the investor's portfolio gains and losses, and trading activity for the year look as follows:

Portfolio:

Mutual Fund A: $250,000 unrealized gain, held for 450 days

Mutual Fund B: $130,000 unrealized loss, held for 635 days

Mutual Fund C: $100,000 unrealized loss, held for 125 days

Trading Activity:

Mutual Fund E: Sold, realized a gain of $200,000. Fund was held for 380 days

Mutual Fund F: Sold, realized a gain of $150,000. Fund was held for 150 days

Without tax-loss harvesting, the tax liability from this activity is:

Tax without harvesting = ($200,000 x 20%) + ($150,000 x 39.6%) = $40,000 + $59,400 = $99,400

If the investor harvested losses by selling Mutual Funds B and C, they would help to offset the gains, and the tax liability would be:

Tax with harvesting = (($200,000 - $130,000) x 20%) + (($150,000 - $100,000) x 39.6%) = $14,000 + $19,800 = $33,800

The proceeds of the sales can then be used to invest in assets similar to the ones sold.