While investing in the stock market over long periods can generate significant wealth, it also comes with significant volatility. Market corrections might be more common than you think, and research from Charles Schwab shows that a decline of at least 10% occurred in 10 out of 20 years—or 50% of the time. So, as an investor, your investment portfolio will likely be down at some point. And while this may be uncomfortable, it can represent an opportunity for tax-loss harvesting.

What is Tax-Loss Harvesting?

Tax-loss harvesting is a strategy where investors sell investments that have lost value. By selling at a loss, you “harvest” that loss, which can then offset taxes on other investments that have gained value. This reduces the overall tax owed, especially on short-term gains, which are taxed at a higher rate.

Here’s why it matters:

If you have investments that have grown in value, selling those investments triggers capital gains taxes. Tax-loss harvesting is a way to lower or even eliminate those capital gains taxes by balancing them out with losses. In short, it’s about using losses to reduce your tax bill.

How Does Tax-Loss Harvesting Work?

Step-by-Step Process:

1. Identify Investments at a Loss:
   • Go through your portfolio to find investments that are currently worth less than what you paid for them. These are the losses you’ll want to “harvest” by selling.
2. Sell to Capture the Loss:
   • Selling these investments locks in the loss, which creates a “harvested loss” that can be used to offset your taxable gains. Remember, this harvested loss is now available as a tool to reduce your taxes.
3. Replace with a Similar Investment:
   • Here’s where tax-loss harvesting preserves your portfolio balance. After you sell the losing investment, you can buy a similar—but not identical—investment to keep your portfolio’s balance and exposure the same. This helps avoid the wash-sale rule, which we’ll cover next.

The Wash-Sale Rule: Avoiding Mistakes

Understanding the Wash-Sale Rule:

When you sell an investment at a loss, the IRS has a rule called the wash-sale rule. This rule says you can’t buy the exact same or a “substantially identical” investment within 30 days before or after the sale. If you do, the tax benefits from that harvested loss disappear.

Here’s how to avoid the wash-sale rule:

If you sell one S&P 500 ETF at a loss, you can replace it with a different S&P 500 ETF from another provider. This keeps you invested in the same type of asset without buying the identical fund, so you still capture any market gains without triggering the wash-sale rule.

How to Use Harvested Losses to Offset Taxes

Now that you’ve harvested losses, here’s how they save you money come tax season.

1. Offsetting Capital Gains:
   • When you sell investments at a gain, those gains are taxable. If you harvested losses, you can apply those losses directly against your gains. Here’s how it works: say you have $10,000 in capital gains for the year but have also harvested $5,000 in losses. You’d only pay taxes on the remaining $5,000 of gains, reducing your tax bill significantly.
2. Offsetting Short-Term vs. Long-Term Gains:
   • It’s essential to know that short-term gains, or gains on investments held less than a year, are taxed at a higher rate than long-term gains. The IRS allows you to offset short-term gains first with short-term losses, which reduces the amount taxed at higher short-term rates. Then, you can offset long-term gains with long-term losses. This maximizes the tax benefits of your harvested losses.
3. Reducing Ordinary Income:
   • What if your harvested losses are more than your capital gains? The IRS allows you to apply up to $3,000 of those losses against your regular income each year. This is especially beneficial if you don’t have enough capital gains to offset. If you’re in a 37% tax bracket, applying $3,000 of losses would save you about $1,100 in taxes on your regular income.
4. Carrying Losses Forward:
   • Finally, if you have more losses than you can use in a single year, you can carry them forward to offset gains or income in future years. Let’s say you harvested $10,000 in losses, but you only had $3,000 in gains this year. After applying $3,000 to reduce your income, you’d still have $4,000 left over. You can carry that forward indefinitely, giving you a “bank” of losses to use in future years.

Example of Tax-Loss Harvesting in Action

Let’s go through a detailed example:

Imagine you invested $20,000 in an ETF, but it dropped to $18,000, leaving you with a $2,000 loss. If you sell this ETF, you’ll have a harvested loss of $2,000.

Now let’s say you also sold another ETF with a $2,000 gain. Normally, you’d owe capital gains taxes on that $2,000 profit. But because of tax-loss harvesting, the $2,000 loss cancels out the $2,000 gain, so you pay no taxes on that gain.

If you had more losses?

Let’s say you had $4,000 in harvested losses and $2,000 in gains. You’d still have $2,000 in losses left, which you could apply to your regular income or carry forward.

Practical Tips for Getting the Most Out of Tax-Loss Harvesting

Tip #1:

Look for daily opportunities to harvest losses, not just at year-end. Some investment platforms monitor for tax-loss harvesting every day, which increases your total harvested losses over time.

Tip #2:

When replacing an investment, choose a similar but not identical asset. For instance, if you sell one large-cap ETF, replace it with another that tracks a similar index to stay compliant with the wash-sale rule.

Tip #3:

Consider the platform fees. While tax-loss harvesting can offset your gains, some platforms charge advisory fees that might reduce the overall benefit. Make sure your savings from tax-loss harvesting exceed any platform fees.

And that’s tax-loss harvesting in depth!

It’s a strategy that, when used wisely, can help reduce your taxes and keep your portfolio balanced. Look for a service (like Range) that offers automated tax-loss harvesting if you want to take advantage of this strategy, and make sure it aligns with your long-term goals.

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