What Is Tax-Loss Harvesting?
Tax-loss harvesting is the selling of securities at a loss to offset a capital gains tax liability. This strategy is typically employed to limit the recognition of short-term capital gains. Short-term capital gains are generally taxed at a higher federal income tax rate than long-term capital gains. However, the method may also offset long-term capital gains.
Understanding Tax-Loss Harvesting
Tax-loss harvesting is also known as "tax-loss selling." Usually, this strategy is implemented near the end of the calendar year but may happen at any time in a tax year.
With tax-loss harvesting, an investment that has an unrealized loss is sold allowing a credit against any realized gains that occurred in the portfolio. The asset sold is then replaced with a similar asset to maintain the portfolio's asset allocation and expected risk and return levels.
For many investors, tax-loss harvesting is the most critical tool for reducing taxes. Although tax-loss harvesting cannot restore an investor to their previous position, it can lessen the severity of the loss. For example, a loss in the value of Security A could be sold to offset the increase in the price of Security B, thus eliminating the capital gains tax liability of Security B.
Example of Tax-Loss Harvesting
Assume an investor earns income that puts them into the highest capital gains tax category (more than $434,550 if single; $488,850 if married filing jointly). They sold investments and realized long-term capital gains, which are subject to a tax rate of 20%. Below are the investor's portfolio gains and losses and trading activity for the year:
- 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
- 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 37%) = $40,000 + $55,500 = $95,500
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 37%) = $14,000 + $18,500 = $32,500
The proceeds of the sales may then be reinvested in assets like the ones sold, although Internal Revenue Service (IRS) rules dictate that investors must wait at least 30 days before purchasing another asset that is “substantially identical” to the asset that was sold at a loss for tax-loss harvesting purposes.
This can help preserve the value of the investor’s portfolio while defraying the cost of capital gains taxes on the profits of the sales of Mutual Fund E and Mutual Fund F. Using the tax-loss harvesting strategy, investors can realize significant tax savings.