Understanding tax-loss and tax-gains harvesting

As the year comes to a close, you might be busy planning for the holiday season. But there’s another planning activity that could also be on your to-do list: planning your capital gains. Now might be a good time to review your capital gains and discuss with your financial advisor and tax professional which tax-smart strategies might be available to you. Trading at an opportune time within your taxable accounts can have a meaningful impact on your capital gains taxes and increase your after-tax investment returns.

What are capital gains/losses?

When you sell or redeem an investment, this can result in a capital gain or loss. Simply put, the gain or loss is the difference between the proceeds from the sale and the cost basis (the total original purchase price of a security including commissions, fees and reinvestments). If you have capital gains during the year, you might have to pay taxes on them.

Capital gains and losses are only relevant for taxable investment accounts (such as a brokerage account). Tax-advantaged accounts, such IRAs, 401(k)s or 529 plans, are not subject to capital gains tax. If taxes apply, withdrawals from these accounts are taxed as ordinary income.

How are capital gains taxed?

Every time you sell investments in a taxable account, the resulting capital gain or loss is classified into short or long term depending on how long you held the investment.

• One year or less: Short term
• More than one year: Long term

To determine how much tax you owe on your capital gains:

1. Subtract all your short-term losses from your short-term gains to obtain your net short-term gain or loss.
2. Then, subtract your long-term losses from your long-term gains to obtain your net long-term gain or loss.

This could result in the following scenarios:

• Both net short-term and net long-term values are gains: The net short-term gains are taxed as ordinary income, while the net long-term gains are taxed at the (more favorable) capital gains tax. The capital gains tax rate is 0%, 15% or 20%, depending on your income level.
• Both net short-term and net long-term values are losses: Up to $3,000 ($1,500 if married filing separately) can be used to offset other types of income. Any amount above this limit can be carried forward to next year and used to offset future capital gains.
• One value results in a gain, the other in a loss: The loss is subtracted from the gain, and the resulting value is used to determine whether there is an overall gain or loss. There are four possible results:

How can I use capital losses strategically (tax-loss harvesting)?

Tax-loss harvesting is a strategy where you sell securities at a loss to offset capital gains. For example, if you sell an investment with a $10,000 taxable gain, you may be able to sell another investment at a $10,000 loss to fully offset it.

Note that tax-loss harvesting is subject to a limitation known as the wash-sale rule. The wash-sale rule prevents you from recognizing a loss if you or your spouse buy a “substantially identical” security within 30 days before or after the sale (the loss is not permanently gone but is deferred until the new securities are sold). Because of this rule, you should consider how tax-loss harvesting will affect your investment strategy. In particular, good candidates for tax-loss harvesting are investments that no longer fit your strategy (for example, when rebalancing your portfolio), have poor investment prospects or can be easily substituted with other investments (for example, with an ETF in the same sector or industry).

How can I use capital gains strategically (tax-gains harvesting)?

There may also be times when it makes sense to harvest your gains instead.

If your taxable income is below a certain threshold, your long-term capital gains will be taxed at 0% up until your taxable income exceeds that threshold. In 2022, this threshold is $41,675 for single filers and $83,350 for married couples filing jointly. For example, let’s say that you and your spouse file jointly and earn $100,000 in 2022. After taking the standard deduction of $25,900, your taxable income is $74,100. The maximum amount of capital gains that can be taxed at the 0% rate is $83,350, which means you can realize $9,250 in gains without paying any federal income taxes.

How do I specify which investments are sold?

If you purchase shares of a security at different prices over time, your cost basis will be different for your different shares. Therefore, you’ll need to be aware which shares are being sold to determine your capital gains.

There are different methods you can use to specify which shares are to be sold, including:

• First in, first out (FIFO)
• Highest in, highest out (HIFO)
• Lowest in, first out (LIFO)
• Specific identification of lots¹

Choosing a cost basis method can be challenging and can have different tax consequences, so you’ll want to consult with your tax professional to be certain that you’re making the appropriate choice for your situation.

Overall, it is important to consider how selling securities impacts your capital gains and the resulting taxes. By working with your tax professional and financial advisor, you can potentially lower your taxes and have additional dollars to put toward your financial goals.