How to Benefit from Tax-Loss Harvesting

Liz Whitteberry |

Tax-loss harvesting helps turn a dip in the market into a tax deduction. This investment strategy can help you lower your overall tax bill and increase your after-tax returns.

In general, tax-loss harvesting is a three-step process. 
1.    You sell a security that has lost value and intentionally realize that loss. 
2.    You use that realized loss to offset the gain on another investment or to offset up to $3,000 of ordinary income.  
3.    You reinvest the proceeds of your sale into a different security or basket of securities.

As an example, let’s assume you invested in Stock A and Stock B.  Two years later, Stock A has gained $50,000 and Stock B has lost $50,000.  

If you sell Stock A to lock in your gain, you will owe capital gains tax on your $50,000 gain. This could cost you $7,500 in tax, assuming 15% capital gains tax.  

If you sell Stock B in the same year, your $50,000 loss on Stock B will offset your $50,000 gain on Stock A.  Your net gain for the year will be $0, and you will owe no tax.  You will save $7,500 in income tax.

You can immediately reinvest the cash from Stock A in anything, even back into Stock A, because you sold it at a gain.  However, you will have to be careful reinvesting the cash from Stock B because of the wash-sale rule.

The wash-sale rule says that if you sell a security at a loss, you cannot buy that same security or a “substantially identical security” within the 30 days before or after the date that you sell the security.  If you do, you will lose the benefit of the loss.

It’s important to realize that the wash-sale rule applies to all of your investment accounts at every institution including retirement accounts. It also applies to your spouse’s accounts.  And it applies to all securities with a CUSIP number: mutual funds, ETFs, individual stocks, bonds, and even options. If you sell a stock at a loss and then immediately buy a call option on that same stock, you will trigger the wash-sale rule.

In the short-term, tax loss harvesting just changes the timeline of your taxes due.  For example, if you sell a fund at loss, you capture some tax savings for the current year.  After the wash-sale period ends, you can buy back into the fund and sell it again later when it’s rebounded back to your original investment.  

The result is you harvest a loss in one year and realize a capital gain of the same amount in a later year.  If your tax rates are the same in both years, you would have been in the same place by waiting for the fund to rebound.

However, if your tax rates are higher when you harvest losses and lower when you ultimately realize gains, you will benefit from tax bracket arbitrage. This allows you to use a loss to offset taxes when they are higher.

You may be able to maximize the benefits of tax bracket arbitrage if you plan to either:

1.    Hold your security until your death.  Your heirs will receive a step-up in basis and can the security at that time with no tax cost.

2.    Donate your security to charity at some point in the future.  The charity will be able to sell the security without tax consequences.

Tax-loss harvesting does not work for all people or in all time periods.  Tax planning helps you make the best decisions for your situation so you can minimize your taxes over your retirement.