Is tax-loss harvesting worth it? Yes — for certain investors

There are a lot of ways to come into money beyond your 9-to-5. If you’ve ever inherited significant assets, you might have been surprised to find an extra-large tax bill tied to the new assets. 

Investments, real estate gains, inheritance, and other earnings aren’t totally free. Unexpected windfalls can feel like a blessing, but you’ll owe taxes on any earned money or awarded assets. 

But there are tips and tricks you pick up along the way to cut your taxes and keep more wealth for yourself, like tax-loss harvesting.

Tax-loss harvesting is a worthwhile way to reduce your tax liability by offsetting capital gains with capital losses. It’s an advanced strategy that’s relatively easy to execute with the help of a financial pro. 

Still, it’s a valuable strategy to have in your back pocket. So here’s everything you need to know about when tax-loss harvesting is worth it and how to save some cash if your earnings increase this year. 

What is tax loss harvesting?

Tax-loss harvesting is the strategic process of selling underperforming assets to offset the gains of well-performing assets. So, if you sell a stock at a $500 loss and sell another with $1,000 earnings, your taxable earnings work out to $500. 

You’ve ditched a poor-performing stock and avoided paying taxes on $500 in gains at the same time. 

Now, you can reinvest those tax savings to beef up your portfolio and potentially increase your earnings.

Once you’re working with huge gains and substantial portfolios, this becomes an extremely effective way to reduce your overall taxable income. But that’s far from the only benefit. 

Benefits of tax-loss harvesting

Tax-loss harvesting is a solid way to cut your tax bill by cashing out losses that reduce your taxable income. This is the first and most obvious benefit (which we’ll dig into), but there are other portfolio boosts to know. 

Reduce your tax liability

If you earn less, you pay less taxes. That’s the gist of how harvesting your taxes can slash your liability to Uncle Sam. 

Your losses offset any gains you earned, so you have fewer dollars to pay taxes on. 

But the U.S. uses marginal tax rates with different tax brackets based on your income. So, in addition to reducing the amount you owe taxes on, you might reduce your income enough to drop into a lower tax bracket, so your taxes are calculated at a lower rate. 

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You don’t have to worry about harvesting losses for every gain. But if you have an exceptional year and need to cash out on windfall profits, tax-loss harvesting is worth the time and effort to save on those expensive taxes.

Rebalance your portfolio

You should rebalance a healthy portfolio at least once a year to ensure your assets align with your goals — tax-loss harvesting can help adjust your asset allocation. 

Typically, investors determine an ideal mix of stocks, bonds, and cash based on their financial goals and risk tolerance — this is your asset allocation. Part of portfolio maintenance is ensuring your asset ratios don’t veer too far off course. 

Let’s say you and your advisor agree on an asset mix with 60% stocks, 25% bonds, and 15% cash. 

You’ll also agree on a maintenance schedule (monthly, quarterly, or annually) and allowable variation (e.g., 5% off target). 

Then, you check on your investments according to the maintenance schedule. You're all good if assets are still largely aligned and within the allowable variation. 

But if you check your allocation and there are major fluctuations, it’s time to adjust and get back to your target allocation. This naturally means selling assets, which is a great time to take advantage of losses to offset taxes on gains. 

Make the most of a down market

We’re not typically rooting for an economic downturn, but it is a natural part of the cycle. We’re here to help you make lemons into lemonade by squeezing your losses for a tax cut. 

When things are tight, you can sell your underperforming stocks and deduct the losses from your taxes for a little extra cash. It doesn’t immediately cash out, but it’s an opportunity to get out from under some riskier assets and tighten your belt looking toward the future. 

If your portfolio is volatile, consider cutting your losses and taking the tax break sooner rather than later. 

Is tax-loss harvesting the right move for you?

This strategy is best for actively managed funds and individual stocks held in taxable brokerage accounts (this strategy doesn’t work in tax-advantaged retirement accounts, since you don’t recognize your gains or losses in the current year). Large index funds aren’t as easy to harvest losses from. 

It’s also geared toward high-net-worth investors with more taxable income. Not only do they have a higher tax rate and a higher potential to save, but their investments are also likely larger, offering a bigger tax cut. 

But other circumstances beyond your net worth play a role, too. If markets are especially volatile and your portfolio is taking a hit, it’s worth considering harvesting your losses. 

Finally, it’s a good move to pull out any time you’re facing a substantial tax bill. If you’ve just sold real estate or received inherited assets from Grandma, tax-loss harvesting can cut down the additional taxes for you. 

Even if your losses are larger than your gains, you can cut up to $3,000 from your taxable income.

How tax-loss harvesting works 

It seems simple enough, but there are a few rules and processes to know before trying to harvest your losses. 

1. You can only harvest taxable losses, so leave your 401(k) and IRA be.
2. You have to finish your transactions by December 31 to include them in the same year’s taxes.
3. Keep track of your long-term vs. short-term assets since they’re taxed differently. Short-term capital gains tax rates are less favorable. 

It’s also important to know how your earnings and losses are calculated. It’s not just about the sales price. Instead, you use your cost basis (original value, plus trade costs, such as fees or commissions, and reinvested dividends) to determine how an asset has performed since purchase. 

That difference in value is what you’re taxed on. So if you bought a stock for $500 and sold it for $750, you owe taxes on the $250 gain, not the $750 sales price. 

The process can get complicated, so we always recommend working with an advisor to avoid accidentally triggering expensive taxes and fees.

Tax rates to know

Earnings from taxable assets like stocks are treated as capital gains, which have two different sets of tax rates depending on the asset’s age. Short-term assets are held for less than a year, while long-term assets are at least a year old. 

Short-term assets are taxed as part of your income with the typical federal income tax rates. 

Long-term capital gains are calculated with a different set of tax rates. They top out at 20% (vs. income tax rates’ 37%), so you’re likely to save a little cash if you hold your assets longer. 

So, if you’re looking to harvest some losses, it might be worth checking out your high-rate, short-term assets first.

High earners also pay a 3.8% net investment income tax if their total income exceeds certain thresholds:

• Single; head of household: $200,000
• Married, filing jointly: $250,000 threshold
• Married, filing separately: $125,000

Must-know wash-sale rules

Wash-sale rules prevent investors from gaming the tax-loss harvesting system, and they’re essential if you want to avoid accidentally triggering heavy fees and taxes. 

Luckily, it’s a pretty easy rule to follow. If you sell an asset at a loss and want to claim it on your taxes, you can’t repurchase a “substantially identical” security within 30 days. 

This is a no-no because you can’t claim a loss on an asset you still own with little to no impact on your portfolio. Otherwise, it would be easy to buy risky stock, cut and cash out your losses on the downturns, then turn around and buy it again for the ride up. 

Loss limits

Your deductible loss is limited by your capital gains, with a small buffer: You can still claim a loss if your loss exceeds your gains, but there’s a $3,000 federal limit ($1,500 if you’re married and filing separately). 

So, if you have a $15,000 loss and no gains, how does that pay off? 

Your losses roll over year-to-year. You can sell for a $15,000 loss and receive a $3,000 annual deduction for the next five years. The IRS has a Capital Loss Carryover Worksheet to help you calculate the details. 

The Playbook take: Turn loss into a wealth-building opportunity

You can’t avoid taxes altogether, but there are plenty of ways to slash your bill. If you’re a high earner or expecting an extra-large tax bill, tax-loss harvesting is worth it to save on taxes and trim the dead weight to support a healthy investment portfolio. 

Want help monitoring your investments and identifying new tax strategies? Get a financial roadmap and personalized advice to build your wealth with Playbook. 

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