Remember this saying: Don’t let the tax tail wag the investment dog. If you choose to implement tax-loss harvesting, be sure to keep in mind that tax savings should not undermine your investing goals. Ultimately, a balanced strategy and frequent reevaluation to ensure that your investments are in line with your objectives is the smart approach.
2 ways tax-loss harvesting can help manage taxes:
The losses can be used to offset investment gains
The losses can offset $3,000 of income on a joint tax return in one year
Unused losses can be carried forward indefinitely
Short-term versus long-term gains and losses
There are 2 types of gains and losses: short-term and long-term.
Short-term capital gains and losses are those realized from the sale of investments that you have owned for 1 year or less.
Long-term capital gains and losses are realized after selling investments held longer than 1 year.
The key difference between short- and long-term gains is the rate at which they are taxed.
Short-term capital gains are taxed at your marginal tax rate as ordinary income. The top marginal federal tax rate on ordinary income is 37%.
For those subject to the net investment income tax (NIIT), which is 3.8%, the effective rate can be as high as 40.8%. And with state and local income taxes added in, the rates can be even higher.
But for long-term capital gains, the capital-gains tax rate applies, and it’s significantly lower.
Gains and losses in mutual funds
If you’re a mutual fund investor, your short- and long-term gains may be in the form of mutual fund distributions. Keep a close eye on your funds’ projected distribution dates for capital gains. Harvested losses can be used to offset these gains.
Short-term capital gains distributions from mutual funds are treated as ordinary income for tax purposes. Unlike short-term capital gains resulting from the sale of securities held directly, the investor cannot offset them with capital losses.
Harvest losses to maximize your tax savings
When looking for tax-loss selling candidates, consider investments that no longer fit your strategy, have poor prospects for future growth, or can be easily replaced by other investments that fill a similar role in your portfolio.
When you’re looking for tax losses, focusing on short-term losses provides the greatest benefit because they are first used to offset short-term gains—and short-term gains are taxed at a higher marginal rate.
According to the tax code, short- and long-term losses must be used first to offset gains of the same type. But if your losses of one type exceed your gains of the same type, then you can apply the excess to the other type. For example, if you were to sell a long-term investment at a $15,000 loss but had only $5,000 in long-term gains for the year, you could apply the remaining $10,000 excess to any short-term gains.
If you have harvested short-term losses but have only unrealized long-term gains, you may want to consider realizing those gains in the future. The least effective use of harvested short-term losses would be to apply them to long-term capital gains. But, depending on the circumstances, that may still be preferable to paying the long-term capital gains tax.
Also, keep in mind that realizing a capital loss can be effective even if you didn’t realize capital gains this year, thanks to the capital loss tax deduction and carryover provisions. The tax code allows joint filers to apply up to $3,000 a year in capital losses to reduce ordinary income, which is taxed at the same rate as short-term capital gains.
If you still have capital losses after applying them first to capital gains and then to ordinary income, you can carry them forward for use in future years.
Stay diversified, but beware of wash sales
After you have decided which investments to sell to realize losses, you’ll have to determine what new investments, if any, to buy. Be careful, however, not to run afoul of the wash-sale rule.
The wash-sale rule states that your tax write-off will be disallowed if you buy the same security, a contract or option to buy the security, or a “substantially identical” security, within 30 days before or after the date you sold the loss-generating investment. People who receive stock or stock-like bonuses from their employer should also consider if their vesting date or employee stock purchase plan (ESPP) purchase date may fall within that 30-day window.
One way to avoid a wash sale on an individual stock, while still investing in the industry of the stock you sold at a loss, would be to consider substituting a mutual fund or an exchange-traded fund (ETF) that targets the same industry.