Tax Loss Harvesting: A Step-by-Step Guide

Tax loss harvesting is the practice of selling investments that have declined in value to realize a… capital loss,Then use that loss to offset capital gains from other investments or up to $3,000 of ordinary income Every year.

The idea is simple: You have already lost money on paper. Selling this investment allows you to record the loss now and reduce your current tax bill. You can then reinvest the proceeds in a similar (but not identical) asset to continue investing.

It’s a legal, IRS-approved strategy — when used carefully.

Simple example

Imagine you bought 100 shares of stock A to $5000. Today these stocks are worth $3000which means that you have $2,000 unrealized loss.

It’s also sold out inventory b Earlier this year for He won $2000.

If you sell Stock A, you can Compensation gains $2000 With your loss of $2,000, creating a net capital gain $0.

If you have no other winnings, you can deduct up to Losses of $3,000 versus ordinary income this year. Any remaining losses can be carried over to future years to be amortized.

You can use The College Investor’s capital gains calculator to estimate your taxes if you haven’t!

How to harvest tax losses

Many robo-advisors include automatic tax loss harvesting as part of their advisory services. But if you’re interested in implementing tax loss harvesting yourself, the good news is that it’s a relatively simple process.

Step 1: Monitor your investment for loss of value

Take the time to monitor your investment portfolio for investments that are losing value. When you notice a significant decline in the value of your investment, it may be time to consider implementing a tax loss harvesting strategy.

Step Two: Sell the investment at a loss

When you find an investment that has lost its value, you can sell it. At this point, you will realize a capital loss. Without making an investment sale, the capital loss remains unrealized and you miss the opportunity to collect tax losses.
For example, let’s say you invest $10,000 in a mutual fund. After six months, the investment value had fallen to $8,000. If you miss the opportunity to sell your investment and it rebounds to $11,000, you won’t be able to use the temporary loss in value to reduce your tax liability.

Step 3: Buy back a similar investment

Once you sell your original investment, it is time to reinvest your money. When selecting a new investment, you’ll need to make sure you’re purchasing something similar but not identical.
The IRS will not allow you to pursue tax loss harvesting if you purchase similar investments, known as a wash sale. A similar investment is not possible.”Pretty much identical“For the original investment.
However, it is possible to purchase different ETFs targeting similar industries. Purchasing a similar investment will allow you to stick to your overall investment goals while taking advantage of short-term losses to minimize tax drawdowns.

Step 4: Claim the loss

Once you’ve worked out the mechanics of a tax loss harvesting transaction, the next step is to claim the loss on your tax return. This last step will allow you to realize your tax loss in a meaningful way.
Depending on your capital gains tax bracket, you could save thousands with the help of this tax minimization strategy.

Tax loss harvesting limits

Although tax loss harvesting can be an exciting way to save thousands, there are some limitations you should be aware of. These restrictions were put in place by the IRS as a way to prevent abuse.

Wash sales rules

The wash sale rule prevents investors from trying to pick up tax losses with similar investments. Under this rule, you cannot claim a capital loss when you sell a security for a capital gain of the exact same security.

Thus, you cannot buy and sell identical securities within 30 days before or after the sale to claim a capital loss. If you go ahead and buy and sell identical securities within 30 days, the IRS will not allow you to claim a tax write-off.
More importantly, you can replace investments with similar mutual funds or ETFs. With similar mutual funds, your portfolio can be relatively similar without violating the wash sale rule.

Important reminder:The wash sale rule does not currently affect the cryptocurrency. If you hold your cryptocurrencies, you can “launder” your cryptocurrencies for tax losses while still holding the same amount of tokens.

Benefits only for taxable accounts

Tax losses can only be captured in taxable investment accounts. Other tax-deferred investment accounts, such as an IRA or 401(k), will not benefit from tax loss harvesting because they are not subject to capital gains taxes.

Ordinary income budget limits

There is no limit to the amount of investment gains that can be offset by tax loss harvesting. However, there is We are Limits on the amount of ordinary income taxes that can be offset.

As a married couple filing jointly or a single filer, you can realize up to $3,000 in capital losses to reduce your ordinary taxable income in a given year. If you are married filing separately, you will only be allowed to claim up to $1,500 in capital losses in a given year.
Because of these limitations, there may be certain years in which you have larger capital gains losses than you can claim on your tax return. The good news is that you can carry these losses over to future tax years.

Additional costs

If you aim to complete a tax-loss transaction every time one of your investments loses value, the strategy can become burdensome in multiple ways.

First, you may incur transaction costs if you do not have a commission-free stock broker. Second, frequent tax loss harvesting can lead to higher tax preparation costs when it comes time to file your tax return.
Before implementing tax loss harvesting in your own portfolio, weigh the costs of completing the transaction and filing your taxes. You don’t want to go to the effort of taking a tax loss if the costs outweigh the savings.

Final thoughts

When considering tax loss harvesting, do not prioritize this strategy over the value of a balanced portfolio. Although you can save on your tax bill with this strategy, it should not take precedence over creating a portfolio that matches your investment goals.
If you’re starting your investing journey, take advantage of our free resources to help you create a portfolio that’s right for you. And if you’re looking for a “set it and forget it” option to harvest tax losses, you may want to open an account with one of the best robo-advisors that can automate all the transactions on your behalf.

Frequently asked questions

Can I use tax loss harvesting for cryptocurrencies?

Yes, crypto losses can be harvested, as cryptocurrencies are considered property by the IRS, not securities. However, note that the buying and selling rules do not currently apply to cryptocurrencies (although Congress has considered changing that).

Does this work for mutual funds and ETFs?

Yes, as long as they are held in taxable accounts and the replacement fund is not closely matched.

Can I harvest losses into my 401(k) or IRA?

No, gains and losses within tax-deferred accounts or Roth accounts are not realized for tax purposes.

What if I don’t have any gains this year?

You can still realize losses. They can offset up to $3,000 in ordinary income this year, and unused losses are carried forward indefinitely.

How much can I save?

Savings depend on your tax bracket. For example, making $5,000 in losses can save you about $750 if you’re in the 15% capital gains bracket.

Do I need a financial advisor for this?

Not necessarily, but a tax professional can help ensure trades are executed correctly and losses are reported correctly.