How tax loss harvesting reduces the tax on your gains

Pursuing better after-tax outcomes is a core part of our Wealth Management and Family Office services. Tax loss harvesting is one strategy investors use to manage taxes. Below, we explain how tax loss harvesting reduces the tax on your gains in many cases, and where its limits lie.

How tax loss harvesting reduces the tax on your gains

First, consider the accounting. The goal is to shrink the net gain below, sometimes into a net loss:

Net gain or net loss = (long term capital gains minus long term capital losses) + (short term capital gains minus short term capital losses).

In other words, the investor sells positions trading below cost to offset gains realized during the year. As a result, the tax owed on those gains may fall or even disappear for that year. Those gains may come from selling positions or from mutual fund capital gain distributions.

However, harvesting often defers tax rather than eliminating it. The replacement typically carries a lower cost basis, so a larger gain may appear on its eventual sale. Trading costs also matter.

In addition, the IRS lets you deduct up to $3,000 of net capital losses against ordinary income each year. For married taxpayers filing separately, the limit is $1,500 (source: IRS Topic No. 409).

Where carryover losses fit

When losses exceed gains, the unused portion can carry forward. In practice, these carryover losses may offset future capital gains, plus up to $3,000 of ordinary income each year. In contrast, tax on realized gains is generally due for the year you realize them.

Why the portfolio comes first

In our view, tax savings should not drive portfolio decisions. Instead, each portfolio should follow its own objectives, and any harvest should fit them. Therefore, knowing how tax loss harvesting reduces the tax on your gains is only half the picture. Most importantly, coordinate this strategy with your accountant and other advisers.

When harvesting may help most

First, harvesting tends to matter most in taxable accounts. Losses inside an IRA or 401(k) generally do not produce a deductible capital loss. For that reason, the strategy usually applies to taxable brokerage accounts. Next, timing plays a role. Market declines can create opportunities at any point in the year, not only in December. For example, an investor who reviews positions after a sharp drop may find losses that would vanish once prices recover.

In addition, the character of a gain affects the value of a loss. Short term gains are generally taxed at ordinary income rates, while long term gains usually receive lower rates. As a result, a loss that offsets short term gains may save more tax. However, the actual benefit depends on each investor’s bracket and circumstances.

Staying clear of the wash sale rule

Of course, advisors should weigh several IRS rules when changing portfolios. A key one is the wash sale rule, which targets sales made purely for a tax benefit. A wash sale occurs if you sell a security at a loss and buy a substantially identical one within 30 days before or after. As a result, the IRS disallows the loss for now and adds it to the new position’s cost basis. In addition, purchases in a spouse’s account or an IRA can count.

For instance, a hypothetical investor could sell an S&P 500 index fund at a loss. Next, the investor could buy a fund tracking the Dow Jones Industrial Average, a related but different index. However, the IRS has not precisely defined ‘substantially identical.’ Meanwhile, the two funds may perform differently. This example is illustrative only, not a recommendation.

Keeping good records

Finally, careful records help at tax time. Your custodian reports sales and cost basis on Form 1099-B, but your accountant still needs the full picture. Therefore, the family should document each harvest, the replacement purchase, and the dates involved. In other words, clear notes make it easier to track carryover losses and spot potential wash sales across accounts.

This article is educational only, not tax, legal, or investment advice; consult a qualified tax professional before acting.