how tax loss harvesting works
tax loss harvesting is also known as tax loss selling most investors use this strategy at the end of the year when they assess the annual performance of their portfolios and its impact on their taxes an investment that shows a loss in value can be sold to claim a credit against the profits that were realized in other assets tax loss harvesting is a tool for reducing overall taxes a loss in the value of security a could be sold to offset the increase in the price of security b thus eliminating the capital gains tax liability of security b using the tax loss harvesting strategy investors can realize significant tax savings if your capital losses for the year exceed your capital gains you can deduct up to 3 000 in net losses from your total annual income if your net losses exceed 3 000 internal revenue service irs rules allow the additional losses to be carried forward into the following tax years 1maintaining your portfolioselling an asset at a loss disrupts the balance of the portfolio after tax loss harvesting investors with carefully constructed portfolios replace the asset sold with a similar asset to maintain the portfolio s asset mix and expected risk and return levels you should avoid buying the same asset that you just sold at a loss which may violate the irs wash sale rule 2losses on your investments are first used to offset capital gains of the same type therefore short term losses are first used to offset short term capital gains tax and long term losses are first used to offset long term capital gains tax but net losses of either type can then be deducted against the other kind of gain 3the wash sale rulethe wash sale rule requires that investors avoid buying the same stock sold at a loss for tax purposes a wash sale involves the sale of one security and within 30 days purchasing a substantially identical stock or security if a transaction is considered a wash sale it cannot be used to offset capital gains and if wash sale rules are abused regulators can impose fines or restrict the individual s trading 2using etfs that track the same or similar indexes can be used to replace one another while avoiding violating the wash sale rule in a tax loss harvesting strategy if you sell one s p 500 index etf at a loss you can buy a different s p 500 index etf to harvest the capital loss example of tax loss harvestingassume a single investor earns an income of 580 000 in 2023 the investor s marginal income tax rate is 37 and is subject to the highest long term capital gains tax category where gains are taxed at 20 short term capital gains are taxed at the investor s marginal rate 41below are the investor s portfolio gains and losses and trading activity for the year portfolio trading activity the tax owed from these sales is if the investor harvested losses by selling mutual funds b and c the sales would help to offset the gains and the tax owed would be 