What tax loss harvesting is & how it works, with examples

Investing inevitably comes with some level of risk, and not every investment will bring the return you were hoping for. If you've lost money on an investment, tax loss harvesting can soften the blow.

Tax loss harvesting is a strategy where you use your investment losses to offset taxable capital gains and save money come tax season. Understanding exactly how it works and the rules you need to follow can help you decide whether it's beneficial for you. If you find yourself with an investment that is worth less than what you paid for it, you can "harvest" that loss by selling the investment and using it to offset taxable gains you've made on other investments. Then you can reinvest the money from the sale to rebalance your portfolio.

The principle behind tax loss harvesting is using your non-qualified investment losses to offset your taxable gains.

Consider this hypothetical example¹:

• You bought stock or mutual fund shares for $10,000 that have now fallen in value to $6,000.
• You also bought another stock or mutual fund for $8,000, but it has performed well and is now worth $15,000. You decide to sell it.

You have realized a $7,000 gain on the investment you sold, which you will owe taxes on. You also can sell your losing investment to harvest the loss, using it to offset the gain on your investment and lower your tax burden. Because you received a $7,000 gain but also have a $4,000 loss, your taxable gain would drop to $3,000.

If your losses are large enough, you can offset your entire gain. You even can deduct up to $3,000 annually from your regular income if your losses are larger than your gains. Any excess loss beyond that $3,000 also can be carried forward to future tax years.

Be aware that this only works with taxable investment accounts. Tax loss harvesting doesn't apply to tax-advantaged retirement accounts because your gains aren't taxed until you withdraw them.

You need to follow a few simple rules to make tax harvesting work for you. The main things to be aware of are how your losses are used to offset gains and how to steer clear of investments called "wash sales," which pose a tax pitfall.

The starting point for calculating your gains and losses is your cost basis. In simple terms, cost basis is the price paid for something. That's easy to see if you bought all your shares at the same price. But if you bought shares at different times, the prices were likely different as well. If you don't sell your entire position, then you'll want to know the cost basis of the specific shares you are selling. You usually can find that on your trade confirmations or account statements.

In the simple example above, you only have one gain and one loss, and it wasn't specified whether they were short- or long-term. In reality, you might have a mix of short- and long-term gains and losses. This distinction matters because of the order you have to follow when offsetting gains with losses.

To arrive at your net taxable gain or deductible loss:

• First, net your short-term losses against short-term gains and long-term losses against long-term gains.
• Then combine your net short-term loss or gain with your net long-term loss or gain.

If it seems tricky, your tax or financial professional can guide you through the calculation.

To harvest a loss, you must sell the investment. That seems straightforward enough, but you'll need to be mindful of the wash-sale rule. It stipulates that in order to deduct a loss, you must not purchase it or a "substantially identical security" less than 30 days before or after the sale. If you do, the loss is disregarded and you will lose the tax benefit. Your tax preparer will help you determine if this applies to you.

Tax loss harvesting can be a useful tool for reducing your tax bill, particularly if you have non-qualified earnings and losses, but you should place it in context with your overall tax and financial plan before deciding if it's the appropriate move. Here are three key factors to keep in mind:

• It's generally more beneficial when you're in a higher tax bracket. Federal income tax rates currently range from a low of 10% to a high of 37%. The higher your tax bracket, the more benefit you receive from tax loss harvesting. If you're in a high tax bracket because you are still working but plan on retiring soon and anticipate being in a lower bracket, then harvesting losses now would provide more benefit.
• Look at how it might affect the rest of your investment portfolio. You shouldn't sell an investment just because you have a loss you can harvest. Be mindful of why you hold the investment in the first place and how selling it would affect your overall portfolio. If you decide to harvest a loss, make sure you have a plan to reinvest the money in a way that is appropriate for your investment objectives and risk tolerance so you can continue to make progress toward your goals.
• If you sell at a loss and reinvest, your cost basis will be lowered as well. That means your future gains may be larger, which is good, but it also means you'll eventually recognize those gains and incur a tax liability. This is part of the reason why a comprehensive long-term plan is so important.

Tax loss harvesting can be an effective tool for increasing tax efficiency, but you need to follow some basic rules to use it effectively and avoid missteps. To explore whether this strategy is right for your current situation or if you want help developing your comprehensive long-term investment plan, connect with a Thrivent financial advisor.