What is Tax-Loss Harvesting?

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Main takeaways

• Tax-loss harvesting lets you offset investment gains with losses, reducing the amount of capital gains tax you owe.

• The wash-sale rule blocks you from claiming losses if you repurchase the same or a substantially similar security within 30 days.

• You can work around the rule by buying similar—but not identical—securities, or by doubling up on shares more than 30 days before selling.

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No matter how financially savvy you are, investing always involves risk. Even the most successful stock-pickers end up with some duds from time to time. 

But it isn’t all bad news when a security you bought takes an unexpected dive. By selling it at the right time, you may be able to save on your tax bill through a strategy known as tax-loss harvesting.

What is tax-loss harvesting?

Tax-loss harvesting is the use of investment losses to offset capital gains, resulting in a lower tax liability. 

To understand how this strategy works, it’s important to get a grasp of how capital gains are taxed by the federal government. Say you buy 100 shares of Company XYZ stock at $5 per share. You’ve invested $500 (100 x $5 purchase price). 

Now imagine that this same stock has increased to $15 a share, and you decide to sell your entire investment. The $10 profit from each share—multiplied by the 100 shares you’re selling—is your capital gain. Now you own a capital gains tax on that $1,000 gain (100 shares x $10 profit). 

Here’s where “harvesting” comes into play. 

Perhaps you have another stock that you’ve sold at a $200 loss during the same year in which you made a profit from those XYZ shares. That loss counts against whatever capital gains you’ve acquired. So instead of owing taxes on $1,000 of capital gains, only $800 is subject to taxes. 

Understanding the wash-sale rule

An effective tax-loss harvesting strategy involves looking at any opportunities to achieve capital losses in order to minimize your capital gains tax—as long as it’s consistent with your long-term investing objectives. 

The obvious candidates to leave on the chopping block are stocks or mutual funds that have underperformed their peers and don’t appear poised for a bounceback. But you may also decide to unload securities you actually like because you can eventually replace them in your portfolio. 

The “wash-sale rule” says you can buy back the same security, or one that’s substantially similar, as long as you wait 30 days. Otherwise you can’t claim the loss as a deduction on your tax return.  

The rule was designed to prevent investors from using short-term losses to achieve tax savings while effectively keeping their position in that very same security. But with a short 30-day waiting period, it’s not exactly a huge deterrent. 

If you’re facing a substantial tax hit from capital gains, then, you might want to look for holdings that happen to have dropped in value from when you first purchased them. You can use the loss to help lower your tax bill, and then buy it right back a month later. 

Tips for getting around the wash-sale rule

Steering clear of the wash-sale rule can help ensure that you maximize your tax savings in the current year. Here are a few strategies that can help you work around it:

• Think about buying securities in the same industry, which tend to be influenced by the same market forces. For instance, if you sell shares of one clothing retailer, you can buy shares of a competing retailer within 30 days and not run afoul of the wash-sale provision.

• Consider “doubling up” on your investment by purchasing additional shares of the security more than 30 days before you sell your losing shares. You then keep the more recently purchased shares.

• Avoid buying the same security through a different account within the 30-day window. For example, selling mutual fund shares in a taxable account and buying them back through your IRA will trigger the wash-sale rule.

The upshot

Tax-loss harvesting can be an effective way to lower your tax liability by using underperforming investments to offset your gains. As long as you steer clear of the wash-sale rule, you can generate tax savings while staying true to your long-term investing goals.