What is tax-loss and tax-gains harvesting?
We all want strong investment performance, but with that comes the potential for capital gains taxes. Fortunately, trading at an opportune time within your taxable accounts can potentially reduce your capital gains taxes and increase your after-tax investment returns.
What are capital gains/losses?
Simply put, a gain or loss is the difference between the proceeds from the sale of an investment and the cost basis (i.e. generally, the total original purchase price of a security including commissions, fees and reinvestments, and can include adjustments for items such as sales, principal returns and corporate actions.). So, if an investment increases in value between the time you purchase and sell the asset, you’ll have a capital gain. On the other hand, if an investment decreases in value within that time frame, you’ll have a capital loss.
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?
In general, when you sell an investment 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. “Short-term” refers to an investment held for one year or less, while “long-term” refers to an investment held for more than one year.
To determine how much you owe in taxes on your capital gains:
- Subtract your short-term losses from your short-term gains to obtain your net short-term gain or loss.
- 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. In this scenario, 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. In this scenario, 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 the following year and used to offset future capital gains.
- One value results in a gain, the other in a loss. In this scenario, the loss is subtracted from the gain, and the resulting value is used to determine whether there is an overall gain or loss, resulting in four possible outcomes:
Result | Tax consequence |
|---|---|
| Net short-term gain > net long-term loss | Short-term gain taxed as ordinary income |
| Net long-term gain > net short-term loss | Long-term gain taxed at capital gains rate |
| Net short-term loss > net long-term gain | Up to $3,000 ($1,500 if married, filing separately) can be used to offset other income. Any excess can be carried forward to the following year as a short-term loss and used to offset future capital gains. |
| Net long-term loss > net short-term gain | Up to $3,000 ($1,500 if married, filing separately) can be used to offset other income. Any excess can be carried forward to the following year as a long-term loss and used to offset future capital gains. |
What is tax-loss harvesting?
Tax-loss harvesting is when you sell some of your investments at a loss to help 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", which prevents you from recognizing a loss if you or your spouse (or a related party) buy a “substantially identical” security within 30 days before or after the sale (i.e., 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, as the benefit of holding on to that investment (and letting it grow over time) may outweigh the benefit of lowering your capital gains tax bill for a given year.
Good candidates for tax-loss harvesting include investments that no longer fit your strategy (when rebalancing your portfolio, for example), have poor investment potential or can be easily substituted with other investments (for example, with an exchange-traded fund (ETF) in the same sector or industry) without violating the wash-sale rule.
What is tax-gains harvesting?
There may also be times when it makes sense to harvest your gains instead. Tax gains harvesting is when you recognize a gain on the sale of securities to incur a smaller amount of tax on that sale. For example, should you have capital losses from current or prior years, you may recognize gains up to the amount of that loss, without incurring additional capital gains tax. 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 2023, this threshold is $44,625 for single filers and $89,250 for married couples filing jointly. So, let’s say that you and your spouse file jointly and earn $100,000 in 2023. After taking the standard deduction of $27,700, your taxable income is $72,300. The maximum amount of capital gains that can be taxed at the 0% rate is $89,250, which means you can realize $16,950 in net gains without paying any federal income taxes.
Tax Harvesting FAQs
What is a watch-out for tax-loss harvesting?
One thing to be aware of with tax-loss harvesting is the wash-sale rule. If you or your spouse purchase the same or substantially identical security within 30 days of selling the security for a loss, then you will not be able to deduct the capital loss on your income tax return.
Is tax-loss harvesting allowed by the IRS?
Tax-loss harvesting can be restricted. If a sale is subject to the wash sale rule, the loss will not be recognized in the year of sale and will be deferred when the corresponding purchase is then re-sold.
How much can you save with tax-loss harvesting?
There is no limit to the amount of losses that can be harvested. However, in any single tax year, losses are limited to the amount of the gains recognized plus an additional $3,000 to offset ordinary income. Excess losses above $3,000 can be carried forward and used to offset future capital gains.
How Edward Jones can help
Overall, there is a lot to consider regarding tax-loss/gain harvesting. Any decisions should be part of a comprehensive investment strategy that aligns with your unique long- and short-term needs. 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.
Important Information:
Edward Jones, its employees and financial advisors cannot provide tax or legal advice. This content should not be depended upon for other than broadly informational purposes. Specific questions should be referred to a qualified tax professional.