Tax loss harvesting: How to offset capital gains with losses

What is tax loss harvesting?

Tax loss harvesting is the process of selling underperforming investments at a loss and using these losses to offset taxes from capital gains. This tax loss harvesting strategy helps you offset capital gains with losses and potentially reduce the tax you owe. If there are still losses left over after offsetting capital gains taxes, you can deduct losses against ordinary income up to $3000 per year.

Let’s look at an example to illustrate this concept.

• Let us say you sold a bunch of stocks this financial year with capital gains of $50,000.
• At a 15% capital gains tax rate, you would pay $7500 in capital gains tax.
• Now let us say you own an underperforming stock that you sell at a loss of $5000.
• This loss of 5000 can be applied against the $50,000 in capital gains, so your net capital gains are now $45,000
• Your new capital gains tax would then be 15% of $45,000 = $6750.
• You save $7500-$6750 = $750.

Thus tax loss harvesting has helped you save $750 by selling underperforming stock. 

So how exactly do we do tax loss harvesting? Below is a step-by-step guide.

How to tax loss harvest in 6 Steps

1. Make a list of underperforming taxable assets (stocks, ETFs, mutual funds, bonds) which are currently below your purchase price. Tax loss harvesting does not apply to retirement accounts, only to taxable stocks, bonds, mutual funds and ETFs.
2. Sell these underperforming assets before December 31. To tax loss harvest for this year, sell these underperforming investments before December 31. This ensures that you can claim the loss for this year’s taxes.
3. Offset capital gains from the losses in stocks sold in this tax year: The losses from the underperforming assets will offset capital gains from stocks sold in this particular tax year.

Note that short term capital losses offset short term gains first before offsetting long term gains, and vice versa. This is because longer term gains are taxed at a different/ lower rate (15% or 20%, depending on one’s income). Short term gains are taxed at ordinary income rates. Therefore the IRS wants to make sure that there is an apples to apples offsetting.

4. Losses ‘left over’ can be used to write off ordinary income, up to $3000 in income. If you still have losses left over beyond the $3000, these can be carried forward to subsequent years and used to offset subsequent capital gains or ordinary income (up to $3000) in subsequent years.
5. Beware of wash sales: you cannot claim a loss if you invest in the same or ‘substantially identical’ assets within 30 days before or after the sale. This rule ensures that people do not game the system by selling an asset to claim a loss and buy back the same asset at the same price.
   • The wash sale rule applies across all accounts, both taxable investments, 401K, Roth IRAs and other retirement accounts. This means that the wash sale rule will apply even if you sell a stock at a loss from your Robinhood brokerage account and then buy it in your Roth IRA.
   • The wash sale rule also applies to spousal accounts. 
6. Rebalance your portfolio: After selling your stocks, review your asset allocation to ensure that you are maintaining your desired asset allocation. Many investors buy similar, but not substantially identical, ETFs or funds so their tax loss harvesting strategy stays aligned with their long-term investment plan. If not, you may want to reinvest in similar asset classes to maintain the same asset allocation. Just make sure you do not reinvest in a substantially identical asset to avoid the wash sale rule.

Frequently asked questions about tax loss harvesting

How do I decide which investments to sell for tax loss harvesting?

• Look for stocks or assets that you believe are lower in value than when you bought them and are highly unlikely to appreciate again.
• If you think they could rebound in value, you may not wish to sell. Alternatively, you can sell them at a loss and buy a similar but not substantially identical asset to maintain your portfolio’s asset allocation. 

Can I just sell a stock at a loss and buy it back again? This way I maintain the same assets while getting a tax break?

• Not immediately. You need to beware of the wash-sale rule which says that tax loss harvesting is not permitted if you buy back the same or a substantially similar security 30 days before or after the sale.
• This rule applies to all accounts including taxable investments and retirement accounts. So if you sell Vanguard S&P ETF from your taxable brokerage account and buy it back in your 401K within 30 days, this would still be considered a wash sale and not eligible for tax loss harvesting.

Tax loss harvesting can be used to offset ordinary income up to $3000. Does this mean that I can get $3000 back in the income taxes I pay?

No it means that you lower your taxable income by $3000. Let us use an example here.

If your annual income is $200,000 it is likely that your marginal federal tax rate could be about 32%. Now if you do tax loss harvesting and have losses of greater than $3000 remaining after offsetting capital gains taxes, you would save $3000 * 32% = $960. 

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