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Investing is usually thought of as a win-or-lose affair: Either your investments make money, or they don’t. The practice of tax-loss harvesting can take some of the sting out of losses. Here are answers to a few common questions on the topic.

Q: What Is Tax-Loss Harvesting?

A: Tax-loss harvesting is a strategy in which underperforming stocks or other assets are sold at a loss. These realized losses can be used to offset capital gains elsewhere in the investment portfolio, effectively neutralizing capital gains tax liabilities. While tax-loss harvesting is primarily used to offset realized capital gains, losses that exceed gains in a given year can be used to offset up to $3,000 of other taxable income as well.

The good news is that the portion of an annual loss exceeding $3,000 can be carried forward for use in future years. Tax-loss harvesting is only used in taxable accounts, because losses in tax-advantaged accounts such as 401(k)s and IRAs aren’t deductible.

Basic Example of Tax-Loss Harvesting

Capital Gain: ABC Corp. Stock

• Realized capital gain: $3,000
• Potential capital gains tax: $600 ($3,000 x 20% tax rate)
• Capital Loss: XYZ Corp. Stock
• Realized capital loss: $10,000
• Loss applied to ABC Corp. gain: $3,000
• Tax liability erased: $600
• Excess loss of $7,000 can be used to offset $3,000 of other income in the current year with $4,000 carried forward to offset future gains.

Q: How Does Tax-Loss Harvesting Impact Diversification in My Portfolio?

A: Maintaining a diversified mix of assets in an investment portfolio is critical when it comes to balancing risk and potential reward. The goal in sustaining proper diversification is to limit the overall impact on your portfolio should specific holdings experience substantial volatility.

To keep portfolios balanced during tax-loss harvesting, it’s usually necessary to reinvest the proceeds from sold assets into similar, but not identical, securities. This strategy captures tax benefits while keeping your portfolio optimized for safely achieving your long-term goals. Because of the interrelationship of portfolio rebalancing and tax-loss harvesting, it’s typically wise to do both simultaneously.

Q: When Is the Best Time to Harvest Losses?

A: It’s common to harvest tax losses toward the end of each calendar year, as this allows you to assess your entire tax situation for the period. If you’ve realized gains over the past several months, you’ll be able to quantify what your tax-loss harvesting target should be. Some investors prefer to harvest losses as opportunities arise throughout the year. For example, a market downturn could present an opportunity to capitalize on immediate losses while providing cash to buy undervalued assets. Ultimately, the optimal timing for tax-loss harvesting depends on your individual financial circumstances and market conditions.

Q: Tax-Loss Harvesting Sounds Simple. What Are the Caveats?

A: It’s certainly simple in concept, but there are plenty of rules that must be followed to pass muster with the IRS.

Understanding the netting rules: short-term losses are first deducted against short-term gains, and long-term losses are deducted against long-term gains. If there are any losses remaining, they can be used to offset the opposite type of gain.

It’s also critical to stay on the right side of the “wash-sale rule.” Under that rule, if an investor sells a security at a loss and buys the same or a “substantially identical” security 30 days before or after the sale, the loss is typically disallowed. Furthermore, it’s critical to know when shares of a certain security in your portfolio were purchased. If you purchased three blocks of a particular stock on different dates, it’s likely that one of those blocks has declined more than the others. To harvest the greatest loss, you must identify the lots of shares you’re selling.

Furthermore, when selling and rebalancing, it’s necessary not just to safeguard diversification within your taxable accounts, but to maintain the right total asset allocation across all your accounts, including tax-advantaged ones. Doing so helps to ensure that your overall investment strategy aligns with your financial goals while optimizing tax efficiency.

This article is intended for informational and educational purposes only. The views expressed do not take into account any individual personal, financial, or tax considerations. As such, the information contained herein is not intended to be personal investment or tax advice or a solicitation to engage in a particular investment or tax strategy. Any opinions contained herein are based on sources of information deemed reliable, but we do not warrant the accuracy of the information. Please consult your tax and financial professional before making any tax, investment or financial-related decisions.

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