End of the Year Investment Tip: Tax Loss Harvesting

By Miranda Marquit

The end of the year is a good time to evaluate your financial situation and make money moves designed to position you for the new year. One of the things to consider as you prepare for a new year is tax loss harvesting.

Tax loss harvesting is a way to offset some of the capital gains you might have had during the year, potentially reducing your taxes.

What are Capital Gains and Losses?

First of all, it’s important to understand capital gains. If you sold your investments for more than you paid, you have a gain. So, let’s say you bought 100 shares of a stock three years ago for $50 a share. You paid $5,000. This year, you sold at $75 per share, or $7,500. You have a gain of $2,500.

Now, Uncle Sam wants the taxes you owe on that gain. If you have an investment for more than a year, you can pay the favorable long-term capital gains tax rate. On the other hand, if you held the stock for a shorter period of time, you end up paying at your regular tax rate.

On the other hand, if you lost money when you sold an investment, that’s a capital loss. It doesn’t matter how long you had it — it’s still a loss. If you bought 100 shares of a stock for $50, but you ended up selling your shares for $20, you’ve got a loss of $3,000. That’s a capital loss.

What is Tax Loss Harvesting?

Tax loss harvesting occurs when you match up your gains with your losses, you can reduce your tax liability.

Let’s say you have that gain of $2,500. If you want to avoid paying capital gains taxes on it, you need to sell a losing stock. Toward the end of the year, many savvy investors who realized gains on some of their investments like to look for underperforming stocks. So, they look for something that has been disappointing, or that no longer fits in their portfolio.

From our example above, you sell a different stock at a total loss of $3,000. You can match that loss with the gain you had earlier in the year. Now, you have a total loss of $500. Not only did that loss offset your gain, resulting in $0 in net taxes on the investment income, but now you have an extra $500 that you can use to reduce your regular income as well.

In fact, if you have extra losses, you can deduct up to $3,000 against your regular income, reducing your tax liability. If you have more than an extra $3,000 in losses, that amount can carry over to a future year, reducing your income — and potentially your tax bill — later.

Tax loss harvesting is a strategy that can help your end of the year finances and put you in a better tax position in the coming year.

Watch Out for the Wash Sale Rule

Now, there is a catch to tax loss harvesting. You can’t just sell a losing stock, claim the deduction, and turn around and buy it while it’s down.

The IRS has what’s known as the wash sale rule. If you buy the same stock again within 30 days of the sale, you can’t claim the loss as a deduction. So, if you decide to use tax loss harvesting as a strategy, you have to be careful of what you buy in the month following the sale of the investment.

It’s a good idea to talk to a tax professional as you try to decide what to sell — and to make sure you’re using tax loss harvesting correctly.

How to Decide Which Stock to Sell

If you want to use tax loss harvesting, you’ll have to decide which stock to sell. First of all, you don’t have to sell all your shares. The important thing is to log a loss that can help offset your capital gains or even reduce your regular taxable income.

As you consider which stock to sell, ask yourself the following questions:

  • Do I think the fundamentals have changed? Should I be getting rid of this stock because it’s become a permanent loser?
  • Does this fit into my portfolio goals? If it no longer fits your strategy, selling can be a strategic way to get into something that better suits your needs.
  • Should I be rebalancing my portfolio? Sometimes, selling a loser is about deciding to rebalance. You can sell a losing stock, harvest the loss, and then buy a different asset to help you rebalance.

Bottom Line

Sometimes, it makes sense to sell an investment when it’s down. If you have gains from earlier in the year, and you don’t want them to have as big an impact on your taxes, you can sell a losing investment. Take the loss and use it to offset your gains, reducing your tax liability.