With the end of the year upon us, let's talk about tax-loss harvesting. This is potentially one of the most important tax moves investors can make this calendar year.
Given that we're in the middle of a raging bull market, this might seem an odd time to discuss portfolio losses. But, if you're like most investors, you probably have a few dogs in your lineup. About 28% of the stocks in the S&P 500 are down this year, with several staring at losses of 20% or more.
Taking the occasional portfolio hit isn't fun, but it happens to all of us. Thankfully, you can use those losses to reduce your tax bill.
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What is tax-loss harvesting?
Think of this as making lemonade out of lemons. Tax-loss harvesting is the process of selling investments that have decreased in value to offset capital gains elsewhere in your portfolio from investments you sold for a profit. The IRS allows you to use these losses to reduce taxable income, potentially saving you money when tax season rolls around.
Here's the basic formula: Capital losses can offset capital gains dollar for dollar. If your losses exceed your gains, you can deduct up to $3,000 ($1,500 if married filing separately) from your ordinary income. Any remaining losses can be carried forward to future tax years.
Why does this matter for investors?
Imagine you sold some stocks this year for a $10,000 profit. Without tax-loss harvesting, you'd owe taxes on that entire gain… and potentially quite a bit. The long-term capital gains tax rate on stocks you've held for at least a year is currently 15% to 20%, depending on your income.
And short-term capital gains on stocks you've held for less than a year are taxed as ordinary income at your marginal tax rate. The highest bracket for 2024 is 37%, plus a potential 3.8% investment income surcharge. So, you could owe anywhere from $1,500 to $4,080 on that $10,000 portfolio return.
But let's say you also sold one of your underperforming stocks at a $7,000 loss. Now, your taxable gain shrinks to just $3,000, massively reducing your potential tax bill.
Note that this only works in regular taxable brokerage accounts. Losses in retirement accounts like a 401(k) or an IRA already enjoy tax benefits, so they cannot be harvested.
Tax-efficient rebalancing
Selling a losing stock position to lower your tax bill is more than just "mopping up" trading gains. It can also be a tax-efficient way to rebalance your portfolio.
Let's say you bought a highflier like Nvidia (NVDA) a few years ago. The chipmaker has been a long-term outperformer and after the epic run it has had, it now makes up a large, disproportionate amount of your portfolio. You recognize it's a risk to have a large concentrated position, but you're not excited about selling and paying taxes on the massive return the semiconductor stock has generated.
One option you have is to sell losing positions elsewhere in your portfolio to carve out a little room to rebalance. If you manage to find $5,000 in losses, for instance, you could sell just enough of that appreciated Nvidia position to realize $5,000 in gains, netting you out at zero.
And what works for single stocks works just as well for exchange-traded funds (ETFs) or mutual funds. You can rebalance your portfolio tax efficiently by selling off some of that highly appreciated S&P 500 ETF and offsetting some of the gains by unloading an underperforming bond ETF.
Beware of the wash-sale rule
One thing you want to watch out for when selling a losing stock position is the wash-sale rule. If you sell a security at a loss, you have to wait at least 30 days before you buy it again or buy a "substantially identical" security. Otherwise, the IRS will disallow the loss.
And this carries over across your accounts. If you sell a security in one account, you can't rebuy it in another account or your spouse's account, even if it's an IRA or other retirement account.
"Substantially identical" might be somewhat subjective. It's clear that you can't sell a share of Microsoft (MSFT) and then repurchase it the next day. Nor could you buy Microsoft call options. But with ETFs, there are some gray areas and the IRS has never fully explained what substantially identical means. In other words, we are left to make our best guess.
For example, if two ETFs or mutual funds track the same index, buying one and selling the other might result in a washed sale. You probably shouldn't sell the SPDR S&P 500 ETF Trust (SPY) and then immediately buy the Vanguard S&P 500 ETF (VOO), but you could potentially sell SPY or VOO and buy the Vanguard Total Stock Market Index Fund ETF Shares (VTI) because it's based on a different underlying index. It wouldn't necessarily matter that the two ETFs hold many of the same stocks and tend to move together with a tight correlation.
Just be smart here and don't push it. It would be a shame to end up paying more taxes than you need to because you got impatient and jumped the gun on a washed sale.
The bottom line on tax-loss harvesting
Tax-loss harvesting doesn't have to be something you only do at the end of the year. Keep it in mind throughout the year or when rebalancing your portfolio. With a thoughtful approach, this technique can be a powerful tool to keep your investment returns growing while trimming your tax bill.
And remember, every dollar you save in taxes is a dollar more you have at your disposal to grow your nest egg.
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