Tax-Loss Harvesting – A Year-End Strategy to Reduce Your Tax Bill

As the year draws to a close, now is an ideal time to review your portfolio for opportunities to reduce your tax liability through tax-loss harvesting. This strategy allows you to offset gains with losses by selling investments that have declined in value, potentially reducing your taxable income. Here’s a closer look at how tax-loss harvesting works, when to consider it, and how to maximize its effectiveness.

How Tax-Loss Harvesting Works
Tax-loss harvesting involves selling investments (such as stocks, mutual funds, or ETFs) that have decreased in value to realize a capital loss. These losses can then offset gains from other investments, reducing your overall tax liability. If your losses exceed your gains, you can use up to $3,000 of those losses against your ordinary income each year and carry any remaining losses forward indefinitely. However, tax-loss harvesting applies only to taxable accounts—not to tax-advantaged accounts like IRAs or 401(k)s.

Key Benefits of Tax-Loss Harvesting

1. Reduces Your Tax Bill: Offsetting capital gains with losses directly reduces your taxable capital gains, effectively lowering your tax bill for the year.
2. Balances Your Portfolio: Selling underperforming investments provides an opportunity to rebalance your portfolio based on your goals and risk tolerance.
3. Defers Taxes Over Time: Excess losses can be carried forward indefinitely, providing tax benefits in future years as well.

Capital Gains Tax Rates: Understanding the Differences
Capital gains are taxed differently depending on the holding period. Short-term capital gains (from assets held for one year or less) are taxed at ordinary income tax rates, which can be as high as 37%. Long-term capital gains (from assets held longer than one year) are typically taxed at lower rates, from 0% to 20%, depending on your income level. Tax-loss harvesting is particularly effective for offsetting short-term gains, as these are taxed at higher rates.

When and How Often to Harvest Losses
While many investors focus on tax-loss harvesting at year-end, it’s also possible to harvest losses throughout the year, especially during market downturns. Regularly reviewing your portfolio for underperforming assets allows you to capture losses when they occur, potentially leading to a more consistent tax benefit and keeping your portfolio aligned with your investment strategy.

Example of Tax-Loss Harvesting in Action
Let’s say you have $10,000 in gains from selling stock earlier this year. You also own a stock that’s lost $5,000 in value since you bought it. By selling this underperforming stock, you can apply the $5,000 loss against your $10,000 gain, effectively reducing your taxable capital gains to $5,000. If your capital gains tax rate is 20%, you could save $1,000 on your tax bill. Any additional losses can be used to offset ordinary income up to $3,000 or carried forward to future years.

Long-Term Implications to Consider
While tax-loss harvesting provides immediate tax benefits, it also reduces the cost basis of your investments. This means that when you sell a reinvested asset at a profit in the future, you may incur a higher capital gains tax due to the lower cost basis. For long-term investors, balancing short-term savings with potential future tax impacts is essential, particularly if you expect your tax rate to rise over time.

Record-Keeping Essentials
Since tax-loss harvesting requires careful tracking, maintaining accurate records is crucial. Ensure you keep documentation of each asset’s purchase price, sale price, and holding period. This information is important for accurately reporting your losses and gains, particularly if you harvest losses multiple times during the year.

Additional Considerations for Tax-Loss Harvesting

1. Alternative Minimum Tax (AMT): Investors subject to the AMT should exercise caution, as tax-loss harvesting may have different implications under AMT rules. Consult a tax advisor if you’re affected by the AMT.
2. State Tax Implications: State tax laws vary, and some states treat capital gains and losses differently than federal rules. For example, not all states allow you to carry losses forward, so it’s wise to check your state’s regulations to understand the full impact.
3. Wash-Sale Rule: The IRS prohibits claiming a tax loss if you buy the same or a “substantially identical” security within 30 days before or after selling it at a loss. To avoid triggering this rule, consider investing in a similar but not identical asset, like an ETF in the same sector, to maintain portfolio exposure.

Exploring Automated Tax-Loss Harvesting Options
Some robo-advisors and investment platforms offer automated tax-loss harvesting services. These platforms can automatically monitor your portfolio, harvest losses, and reinvest in similar assets while avoiding the wash-sale rule. Automated services can simplify the process, but it’s still wise to understand the potential tax implications and confirm that it aligns with your financial goals.

Final Thoughts: Is Tax-Loss Harvesting Right for You?
Tax-loss harvesting can be a valuable tool for investors in taxable accounts, providing both short-term tax savings and long-term tax management potential. By understanding the nuances of capital gains tax rates, frequency, and applicable regulations, you can make the most of tax-loss harvesting in a way that complements your financial plan. For personalized guidance, consider consulting a tax professional or financial advisor, especially if you’re subject to the AMT or state-specific tax rules.

With thoughtful application, tax-loss harvesting can be a powerful component of your year-end tax strategy and an effective way to prepare for a tax-smart 2025.