How to Cut Your Tax Bill with Tax-Loss Harvesting

Not every investment will be a winner. Fortunately, even losing investments come with a silver lining: You may be able to use those losses to lower your tax liability and reposition your portfolio for the future. 

This strategy is known as tax-loss harvesting, and it's one technique investors can use to make their investments more tax-efficient.

Tax-loss harvesting generally works like this: 

1. You sell an investment that's underperforming and losing money. 
2. Then, you use that loss to reduce your taxable capital gains and potentially offset up to $3,000 of your ordinary income.
3. Finally, you reinvest the money from the sale in a different security that meets your investment needs and asset-allocation strategy. 

The principle behind tax-loss harvesting is fairly straightforward, but it does involve some potential pitfalls you should try to avoid. 

Imagine you're reviewing your portfolio and see that your industrial stocks have dropped in value while your tech holdings have risen sharply. As a result, the industrial sector now accounts for less of your stock allocation than you'd prefer, while the tech sector is overweight. 

To get your portfolio closer to your target allocation—a portfolio-maintenance practice known as rebalancing—you would sell your industrial-sector losers for a loss, as well as some of your tech stocks for a gain. 

This allows you to do two things:

• You can use the proceeds of these sales to buy other industrial stocks whose prospects you prefer, bringing your portfolio back to its target allocation. 
• You can use the value of your loss from the industrial shares to offset the taxable gains from the sale of your tech shares, thereby reducing your tax liability. 

Furthermore, if your losses are larger than the gains, you can use the remaining losses to offset up to $3,000 of your ordinary taxable income (for married couples filing separately, the limit is $1,500). Any amount over $3,000 can be carried forward to future tax years to offset income down the road.

For example, let's say you recognize a gain of $20,000 on a stock you bought less than a year ago (Investment A). Because you held the stock for less than a year, the gain is treated as a short-term capital gain and will be taxed at the higher ordinary-income rates rather than the lower long-term capital-gain rates, which apply to investments held for more than a year. 

At the same time, you also sell shares of another stock for a short-term capital loss of $25,000 (Investment B). Your $25,000 loss would offset the full $20,000 gain from Investment A, meaning you'd owe no taxes on the gain, and you could use the remaining $5,000 loss to offset $3,000 of your ordinary income. The leftover $2,000 loss could then be carried forward to offset income in future tax years. Assuming you're subject to a 35% marginal tax rate, the overall tax benefit of harvesting those losses could be as much as $8,050. 

By offsetting the capital gains of Investment A with your capital loss from Investment B, you could potentially save $7,000 on taxes ($20,000 × 35%). Because you lost $5,000 more than you gained ($25,000 – $20,000), you can reduce your ordinary income by $3,000, potentially lowering your tax liability an additional $1,050 ($3,000 × 35%), for a total savings of $8,050 ($7,000 + $1,050). You could then apply the remaining $2,000 of your capital loss from Investment B ($5,000 – $3,000) to gains or income the following tax year.

As with any tax-related topic, there are rules and limitations:

• Tax-loss harvesting isn't useful in retirement accounts, such as a 401(k) or an IRA, because you can't deduct the losses generated in a tax-deferred account.
• Long-term losses are first applied to long-term gains, while short-term losses applied to short-term gains. If you have excess losses in one category, you can apply them to gains of either type.
• When conducting these types of transactions, you should also be aware of the wash-sale rule, which states that if you sell a security at a loss and buy the same or a "substantially identical" security within 30 days before or after the sale, the loss is typically disallowed for current income tax purposes. 

Even if you don't have capital gains to offset, tax-loss harvesting could still help you reduce your income tax liability.

Let's say Sofia, a single income-tax filer, holds XYZ stock. She originally bought it for $10,000, but it's now worth only $7,000. She could sell those holdings and take a $3,000 loss. Then, she could use the proceeds to buy shares of ZYY stock (a similar but not substantially identical stock) after determining that it's as good as or better than XYZ. 

Sofia could use the $3,000 capital loss from XYZ to reduce her taxable income for the current year. If her combined marginal tax rate is 30%, she could receive a current income tax benefit of up to $900 ($3,000 × 30%). She could then turn around and invest her tax savings back in the market. If she assumes an average annual return of 6%, reinvesting $900 each year could potentially amount to approximately $35,000 after 20 years.

Harvesting losses regularly and proactively—when you rebalance your portfolio, for instance— can save you money over the long run, effectively boosting your after-tax return.