Tax-Loss Harvesting: Reduce Taxes in Your Brokerage Account

Tax-loss harvesting is a powerful strategy within taxable brokerage accounts that can directly reduce your tax bill. It might sound complex, but the core concept is quite straightforward: you sell investments that have lost value to generate capital losses, and then use those losses to offset capital gains and potentially even some of your ordinary income. By strategically realizing losses, you can legally lower your tax liability and potentially improve your after-tax investment returns.

Let’s break down how this works. First, it’s important to understand the basics of capital gains and losses. When you sell an investment like a stock or ETF for more than you originally paid for it, you have a capital gain. Conversely, if you sell for less than you paid, you have a capital loss. The IRS taxes capital gains, and allows you to deduct capital losses, with certain rules.

Tax-loss harvesting leverages these rules. Imagine you hold two stocks in your taxable brokerage account. Stock A has increased in value, creating an unrealized capital gain. Stock B, unfortunately, has decreased in value, resulting in an unrealized capital loss. Tax-loss harvesting would involve selling Stock B to realize that capital loss.

Once you’ve realized the loss, you can use it to offset capital gains you’ve realized during the same tax year. For example, if you sold Stock A and realized a $2,000 capital gain, and you harvested a $1,500 capital loss from selling Stock B, you can use the $1,500 loss to offset the $2,000 gain. Instead of being taxed on the full $2,000 gain, you would only be taxed on the net gain of $500 ($2,000 gain – $1,500 loss). This directly reduces your capital gains tax liability.

But the benefits of tax-loss harvesting can extend even further. If your capital losses exceed your capital gains in a given year, you can actually deduct up to $3,000 of those excess losses against your ordinary income, such as your salary. Any remaining capital losses beyond that $3,000 limit can be carried forward indefinitely to future tax years to offset capital gains or, again, up to $3,000 of ordinary income each year. This carry-forward provision is particularly valuable as it allows you to utilize losses even if you don’t have immediate capital gains to offset.

A crucial rule to be aware of when tax-loss harvesting is the “wash-sale” rule. This rule prevents you from immediately repurchasing the same or “substantially identical” investment within 30 days before or after selling it to claim a tax loss. The IRS considers this an attempt to artificially generate a tax benefit without actually changing your investment position. If you violate the wash-sale rule, the tax loss will be disallowed.

To avoid triggering the wash-sale rule, you have a few options. You can wait more than 30 days to repurchase the same security. Alternatively, you can invest in a similar, but not “substantially identical,” asset. For example, if you sell an S&P 500 ETF to harvest a loss, you could immediately reinvest in a different S&P 500 ETF from a different provider, or perhaps a broad market ETF that tracks a slightly different index but offers similar market exposure. Consulting with a financial advisor can help you navigate these nuances and ensure compliance with the wash-sale rule.

Tax-loss harvesting is generally most beneficial in years when you have realized capital gains or expect to realize them in the future. It’s also particularly useful during market downturns when you are more likely to have investments with unrealized losses. It’s a strategic tool to proactively manage your tax liability and potentially enhance your long-term investment outcomes. While it can seem like a small action – selling a losing investment – the cumulative tax savings over time, especially for investors with larger taxable brokerage accounts, can be significant. Remember to keep detailed records of your transactions and consult with a tax professional or financial advisor to ensure you are implementing tax-loss harvesting effectively and in accordance with all applicable tax rules.