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Tax-Loss Harvesting – Rules, Examples & How It Works

Managing an investment portfolio can be complicated on the best of days. You have to come up with a target asset allocation, select the securities and mutual funds you think can help you reach that target, and monitor the portfolio’s performance. Then over time, you have to reassess your investing goals, add additional funds, and rebalance the portfolio.

Advanced strategies can be even more complicated, but they’re worth considering. One such strategy is tax-loss harvesting, which lets you use underperforming assets to reduce your tax burden. Here’s how it works and how it can help you keep more of your money.

How Tax-Loss Harvesting Works

Tax-loss harvesting is a practice that takes advantage of the rules that let you use capital losses to offset other forms of taxable income.

At its most basic, tax-loss harvesting involves intentionally selling poorly performing investments for a loss and reinvesting the proceeds back into the market. It lets you book a capital loss while keeping your money invested in the market.

Tax-loss harvesting reduces the cost basis of your investments while letting you reduce the tax you owe in the immediate future.

Cost Basis

The first thing that goes into tax-loss harvesting is cost basis. The cost basis of an asset is simply the price you paid to purchase that asset. For example, if you bought 10 shares in a mutual fund for $100 per share, you have a cost basis of $100 for each share. If the shares lose value and go down in price to $95, your cost basis for the shares remains $100. If they increase in price to $105, your cost basis for each share also remains $100.

The cost basis of a share comes into play when calculating capital gains and losses.

There are different options for calculating the cost basis, depending on the type of asset you’re buying and selling. For things like stocks, you track the cost basis of each share individually. When you sell shares, you must choose which shares to sell.

Typically, your broker lets you choose either last-in, first-out (LIFO) or first-in, first-out (FIFO) methods of account. When using LIFO, you sell the most recent shares you purchased first. When using FIFO, you sell shares in the order you bought them. Some brokers let you specify individual shares or choose to sell shares in order from highest to lowest or lowest to highest cost basis.

When you sell shares in mutual funds, many brokers offer the option to use the average cost of a share as your cost basis. That means the cost basis declared is the average price you paid for each share you own. If you bought 10 shares at $1, five shares at $2, and five shares at $5, the average cost basis would be:

[(10 x $1) + (5 x $2) + (5 x $5)] / 20 shares = $2.25

Pro tip: Online brokers like M1 Finance use technology to help investors choose the method that will offer the lowest tax liability.

Capital Gains & Losses

When you sell an asset, you earn a capital gain or loss based on the sale price and your cost basis.

If you sell something for more than you paid, you make a capital gain. If you sell something for less than you paid, you make a capital loss.

That’s why the cost basis for your investments is so important. Consider this example:

You own 100 shares of company XYZ. You paid $20 for 50 of the shares and $30 for the other 50 shares. Currently, company XYZ trades at $25.

If you decide to sell 50 shares, you could make a capital gain or a capital loss based on the shares you choose to sell. If you sell the shares with a $20 cost basis, you can earn a capital gain. Selling the shares with a $30 cost basis results in a capital loss.

Reducing your cost basis through tax-loss harvesting means you can earn more substantial capital gains when you later sell your investments. In short, you pay less tax now but more tax later. Money tends to be more valuable in the present than in the future because you have more time to invest it and let it grow and more flexibility to use it if you need to. That makes tax-loss harvesting a net positive financially.

Taxes on Capital Gains & Losses

For tax purposes, you must report capital gains and losses to your state and federal governments. Just like other forms of income, the government wants a cut of your investment income, including capital gains.

At the federal level, there are two different types of capital gains: short-term gains and long-term gains.

Short-term capital gains are capital gains you earn on investments you owned for a year or less. The government taxes short-term capital gains at your normal income tax rates.

Long-term capital gains taxes apply to gains made on investments you owned for more than one year. The long-term capital gains tax is lower than the standard income taxes. For 2019, the long-term capital gains tax brackets are:

Filing Status0% Long-Term Capital Gains Tax15% Long-Term Capital Gains Tax20% Long-Term Capital Gains Tax
Single$0 – $39,375$39,376 – $434,500More than $434,500
Head of Household$0 – $52,750$52,751 – $461,700More than $461,700
Married Filing Jointly$0 – $78,750$78,751 – $488,850More than $488,850
Married Filing Separately$0 – $39,375$37,376 – $434,500More than $434,500

The long-term capital gains tax rate is far below the regular income tax rate, capping out at 20% compared to the maximum of 37% for regular income. That means you can save a lot of money on your taxes by earning long-term instead of short-term gains.

When you sell an investment for a tax loss, the government lets you deduct it from your other income because it taxes you on your net income. That means the government won’t tax someone who made $1,000 on one trade if they lost $10,000 on another trade and wound up losing $9,000 over the year.

You can use your capital losses to offset your capital gains without limit. If you have losses of $100,000 and gains of $100,000, you can report your total investment income as $0, meaning you owe no capital gains tax.

Moreover, if you have more capital losses than capital gains, you can use your losses to offset up to $3,000 in noninvestment income each year. For example, say your taxable income from your employer is $50,000. If you sold an investment for a loss of $1,500 and earned no capital gains throughout the year, you can use that capital loss to reduce your normal taxable income to $48,500. If you book a capital loss of $4,500, you can use up to $3,000 of that to reduce your taxable income to $47,000. But that additional $1,500 isn’t gone forever.

That holds true even if you lose a lot of money in a single year. Your tax losses don’t disappear after the year ends.

If you can’t use all your capital losses to offset other income, you can carry them forward indefinitely. If you report $30,000 of capital losses in one year and earn no capital gains, you can use $3,000 of the loss to reduce your regular taxable income and carry the remaining $27,000 loss into the next year.

You can use the remaining $27,000 loss to offset that year’s capital gains plus an additional $3,000 in regular income. If you still have part of that loss remaining, you can carry it forward again. For example, if you don’t sell any stocks in the next year, you can apply $3,000 of the remaining $27,000 loss to offset your income and carry the remaining $24,000 loss forward.

If you sell stocks for a loss in a future year, you can add it to the losses you carried forward. There’s no expiration date on tax losses. You can use them to offset income until you’ve exhausted all your tax losses.

The Wash-Sale Rule

Tax-loss harvesting isn’t always as simple as selling an asset at a loss and reinvesting the money in the market. There is one rule you have to follow.

The wash-sale rule prevents you from selling and buying the same or similar assets just to create a capital loss. When a wash sale occurs, you can’t use any of the capital losses from the sale to offset other income for tax purposes.

A wash sale occurs when you buy a “substantially identical” security within the 30 days before or after the sale that created the loss. Many securities are incredibly similar. It’s most common for mutual funds. Multiple funds from different companies can track the same stock index or industries. In short, if two exchange-traded funds (ETFs) or mutual funds would serve the same purpose in your portfolio, they’re probably substantially similar.

For example, say you own shares in the SPDR S&P 500 ETF Trust (SPY), an ETF that tracks the S&P 500. You can sell those shares and use the proceeds to buy shares in the Vanguard 500 Index Fund Admiral Shares (VFIAX), a mutual fund that tracks the S&P 500. Even though you haven’t bought and sold the same security, you’re investing in the same basic things. The wash-sale rule makes this type of transaction ineffective if you’re trying to tax-loss harvest because the assets track the same stock index.

The wash-sale rule makes tax-loss harvesting very complicated to do on your own. You want to keep your money invested and hit your target asset allocation, but the wash-sale rule means you’re locked out of certain investments when tax-loss harvesting.

How Tax-Loss Harvesting Impacts Your Portfolio’s Returns

Though tax-loss harvesting is complicated, it can have a significant impact on your portfolio’s returns. It means you can leave more money in your portfolio instead of paying it to the IRS.

According to robo-advisory firm Wealthfront, its clients saw benefits of 3.12% to 6.24% of portfolio values from the firm’s tax-loss harvesting services during 2018. Even such seemingly small percentages could be a difference of tens of thousands of dollars for portfolios with more than $200,000 in them.

Leveraging Robo-Advisory Firms for Tax-Loss Harvesting

Robo-advisors are companies that use complex algorithms and computer programs to manage your portfolio for you. Most robo-advisors use your risk tolerance and desired asset allocation to invest in a range of ETFs and mutual funds that let you track the world’s stock market.

Because the programs can easily handle more complex transactions than a human, almost all the major robo-advisory services offer tax-loss harvesting services. If you have a lot of money in taxable brokerage accounts, robo-advisors make tax-loss harvesting much easier. You don’t have to move large amounts of money or find a way to structure your portfolio while avoiding the wash-sale rule. Good robo-advisors — like Betterment, Personal Capital, Wealthfront, and Schwab Intelligent Portfolios — do it all for you.

Betterment

Betterment offers robo-advisory services at a cost of 0.25% of invested assets each year with no minimum balance. Their fee includes tax-loss harvesting services. The company advertises many features that appeal to investors who want to save without much effort, such as:

  • No additional trading commission
  • Automatic reinvestment of harvested losses
  • No short-term capital gains taxes
  • Automatic rebalancing

Betterment estimates that the additional returns produced by its tax-loss harvesting service will outpace its 0.25% management fee.

Personal Capital

With a minimum investment of $100,000, Personal Capital offers its tax-optimization services, including tax-loss harvesting, to all customers. The company stands out because of its willingness to invest in individual stocks over ETFs and the fact that it provides more human interaction with financial advisors than other robo-advisors.

Read our Personal Capital review.

M1 Finance

M1 Finance offers more customization than many of its competitors. You can choose from one of a variety of expert portfolios based on your risk or create your own. M1 Finance handles the investing and rebalancing for you.

The company doesn’t offer typical tax-loss harvesting services to its customers. Instead, it aims to help with the tax-efficient withdrawal of funds. When you request a withdrawal, M1 Finance sells securities in a specific order:

  1. Shares that result in losses that offset future gains
  2. Shares you’ve held long enough to pay the lower long-term capital gains rate
  3. Shares you’ve held for less than a year, requiring you to pay the higher short-term capital gains rate

This strategy minimizes your tax bill when you make a sale.

Wealthfront

Wealthfront, like Betterment, invests your money in a variety of low-cost ETFs, charging 0.25% each year for its services. They offer tax-loss harvesting to all account holders regardless of balance. The minimum balance to invest is $500. But customers with a balance of at least $100,000 get access to the more advanced stock-level tax-loss harvesting, which uses movements within individual stocks to harvest more losses.

Schwab Intelligent Portfolios

Schwab Intelligent Portfolios is an automated investing service with a $5,000 minimum investment. Most notably, it doesn’t charge any investment or advisory fees, which is a good deal compared to its competitors. It makes up for this by investing primarily in Schwab’s ETFs. Once you have $50,000 or more in your account, you can sign up for its free tax-loss harvesting service.

Final Word

Tax-loss harvesting is a complicated investing strategy that can help you reduce your tax burden and keep more money in your portfolio. In most cases, the burden of tax-loss harvesting is too high for investors to do on their own. Working with a robo-advisor lets you take full advantage of the benefits of tax-loss harvesting. The trick is choosing the right one. The best robo-advisory services have low fees and offer all their services to customers, regardless of their account balance.

Do you tax-loss harvest or use a robo-advisor? Which robo-advisor do you use?

TJ Porter
TJ is a Boston-based writer who focuses on credit cards, credit, and bank accounts. When he's not writing about all things personal finance, he enjoys cooking, esports, soccer, hockey, and games of the video and board varieties.

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