If you’re looking for ways to lower your taxes, check your investment portfolio for losses. You may be able to lower your tax bill by selling at a loss and immediately reinvesting.
What is tax loss harvesting?
Tax loss harvesting is a tax strategy where you sell an investment that’s down so you can claim a capital loss. If you want to stay invested, you immediately buy a similar investment.
You can do tax loss harvesting with stocks, ETFs, mutual funds, and other types of investments.
Example of Tax Loss Harvesting
Your S&P 500 index fund is down $10,000 since you bought it. If you sell it, you can claim the $10,000 capital loss as a write-off on your taxes.
But you don’t want to take your money out of the market. You just want to save on taxes. So you reinvest all of the money in a Total Stock Market index fund or other fund that’s similar to the S&P 500 index.
How big is the tax write-off?
When you claim a capital loss by selling an investment:
- It first offsets any capital gains you had from selling investments that were up
- Up to $3,000 of any remaining loss will offset ordinary income (interest, dividends, wages, business income, etc.)
- Any remaining loss above $3,000 can be used in future years
What are the restrictions?
The biggest restriction is the wash sale rule. The wash sale rule says that you lose your loss write-off if you buy a substantially identical security within 30 days.
Basically, you can’t invest in the same thing for another 30 days.
Also, you can only claim a loss in taxable accounts. You can’t claim capital losses in IRAs, 401(k)s, or other tax-advantaged plans.
- Common tax loss harvesting strategy: Sell S&P 500 fund and buy Total Stock Market fund (or the opposite).
- Wash sale: Selling one S&P 500 fund and buying another S&P 500 fund — even though it’s a different fund company, you’re investing in the same thing.
- Gray area: Selling a Total Stock Market fund tracking the CRSP index and buying a Total Stock Market fund tracking the S&P index. The two indexes have slight differences, but the IRS has never given a firm answer on whether the fact that both funds are trying to match the total stock market makes them substantially identical.
Wash sales include:
- Buying in the same account
- Buying in another account
- Buying in an IRA, 401(k), or other retirement account
- Reinvested dividends
Do you have to buy a similar investment?
You don’t have to buy a similar investment to claim a capital loss. The tax loss harvesting strategy assumes you want to keep your investments the same while claiming a tax loss.
If you want to sell a stock fund and buy a bond fund, you can sell stock fund shares that are down and claim a loss.
Make sure you pick the shares you sell.
Your broker should give you an option to pick which shares you sell. Make sure you’re selling the shares that have a loss and not any shares that have a gain.
Tax loss harvesting may increase your taxes in future years.
One word of caution about tax loss harvesting is that it may increase your taxes in future years.
Let’s say you’re down $10,000 in Fund A today. Over the next 5 years, Fund A and Fund B both go up $20,000.
- If you use tax loss harvesting to sell Fund A and buy Fund B: You can claim a $10,000 loss this year. In five years, you’ll have a $20,000 taxable gain on Fund B.
- If you hold Fund A: You don’t claim a loss this year. In five years, you’ll only have a $10,000 taxable gain (-$10,000 + $20,000 = $10,000).
So the first option can save you more now, while the second option can save you more in the future. But depending on your overall income, changes in tax brackets, and other factors, which one saves you more over time can vary.
If you want the sure tax benefit now, consider tax loss harvesting. If your taxes are relatively low this year and you expect them to be higher later, maybe don’t use tax loss harvesting.