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.
BREAKING DOWN 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 which 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.
Tax-Loss Harvesting Example
Assume an investor as of 2018, has the income that puts that person into the highest capital gains tax category (more than $425,00 if single, $479,000 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 reinvested in assets like the ones sold.