What is tax loss harvesting?
Tax loss harvesting is one of the most-utilized methods for reducing capital gains tax.If you have realized capital gains (i.e., you sold a security for a profit earlier in the year), you might want to reduce the capital gains tax you'll be responsible for early the next year.You can effectively tax loss harvest by selling investments with unrealized losses and applying those losses against previously realized gains.Imagine you bought a stock two years ago for $5,000 and it rose to $10,000 this year. You then sold the stock for a $5,000 long-term capital gain.You also own a different stock you bought two years ago for $10,000, and it's now worth $5,000. You sell the stock for a $5,000 long-term capital loss.By harvesting the loss and transitioning it from unrealized to realized, you're able to offset your existing $5,000 long-term capital gain and bring your net capital gain for the year down to zero.Zero capital gains means zero capital gains tax, and zero capital gains tax often means a happy taxpayer.
Tax loss harvesting rulesThere are a few important rules you should know if you're attempting to use tax loss harvesting in your own portfolio.
First, tax loss harvesting won't work in a 401(k), 403(b), IRA, or any other tax-advantaged investment account. Trading activity isn't taxed in these accounts; instead, you're taxed when you withdraw money (except if you're investing in a Roth account, in which case you've already been taxed on the money inside).
For tax loss harvesting to be applicable, you'll need to be working inside a taxable brokerage account.Next, you'll need to be aware that tax loss harvesting involves applying short-term losses against short-term realized gains, and long-term losses against long-term realized gains. If you're left with a loss in one category and a gain in the other, you can offset the two to come up with a final net number for capital gains.This amount (if positive) is added to your income for the year; if your net number is negative, it can be used to offset as much as $3,000 worth of ordinary income for the year. Note that the maximum annual limit for capital loss deduction is $3,000, regardless of your filing status (i.e., the limit doesn't jump to $6,000 for married filers).Any losses in excess of the $3,000 limit can be carried forward indefinitely. This means that you can use a large loss in one year to cover future years' capital gains if you're fortunate enough to have them.Note that even if you have positive capital gains for the year, you may not pay the same tax rate on them as you do for the rest of your income. Still, if you have a short-term capital gain, you'll pay ordinary income tax on the gain.If you have a long-term capital gain, on the other hand, you'll be eligible for favorable tax rates ranging from 0% to 20%, depending on your total income level.Finally, you'll need to be aware of the wash sale rules, which we'll cover in the section below.
What is a wash sale?
To harvest tax losses, all you have to do is sell a security with an unrealized loss. However, you can't simply buy back the stock immediately. To comply with the wash sale rules, you have to stay out of the stock for at least 30 days after the sale. If you don't, then you can't harvest that tax loss. But once you wait out the period, then you can buy back the stock with no tax penalty.The wash sale rule can make it difficult to harvest tax losses from a stock that you hope to rebound. By being out of the stock for roughly a month, you might well miss out on a sizable share-price gain. However, the IRS thinks these measures are necessary to prevent abuse of the tax loss harvesting strategy.