How to Use Tax-Loss Harvesting to Reduce Your Tax Liability

For investors looking to reduce tax liability while keeping their portfolios optimized for growth, a tax-loss harvesting strategy can be a valuable tool. By strategically selling underperforming investments to offset capital gains, investors can minimize their tax burden and improve their after-tax returns.

Understanding how tax-loss harvesting works, when to apply it, and how it fits within a broader tax-efficient investing strategy can help investors make smarter decisions and maximize their wealth over time.

What Is Tax-Loss Harvesting?

Tax-loss harvesting is the process of selling investments that have lost value to offset capital gains taxes owed on profitable investments. Investors can use this strategy to lower their overall tax bill while reinvesting in similar assets to maintain their investment exposure.

Key Benefits:

• Offsets capital gains, reducing taxable income.
• Helps manage investment losses while staying in the market.
• Can be applied annually to optimize long-term tax efficiency.

Tax-loss harvesting is particularly useful for investors in taxable accounts, as retirement accounts like 401(k)s and IRAs already offer tax-deferred growth.

How Tax-Loss Harvesting Works

1. Identify Losing Investments: Review your portfolio for investments that have declined in value.
2. Sell Underperforming Assets: Sell investments at a loss to generate tax deductions.
3. Offset Gains: Use those losses to offset capital gains from other profitable investments.
4. Reinvest Strategically: Purchase similar investments to maintain portfolio diversification while avoiding the wash-sale rule (which prevents buying back the same or substantially identical security within 30 days).
5. Apply Excess Losses to Income: If losses exceed gains, up to $3,000 per year can be deducted from ordinary income, with additional losses carried forward to future tax years.

Strategies for Tax-Loss Harvesting

Sell Losing Investments, Reinvest in Similar Assets

• Selling an investment at a loss doesn’t mean sitting on the sidelines.
• Investors can buy similar assets that align with their portfolio strategy while staying within IRS rules.

Time Harvesting to Optimize Tax Benefits

• Year-end is a common time for tax-loss harvesting, but it can be applied throughout the year.
• Regular portfolio reviews help capture losses without waiting until December.

Use Harvested Losses Wisely

• Offset short-term capital gains first, as they are taxed at higher ordinary income rates.
• Apply excess losses to long-term gains or up to $3,000 of ordinary income.

Beware of the Wash-Sale Rule

• The IRS prohibits repurchasing the same (or substantially identical) investment within 30 days.
• To stay compliant, investors should choose alternative investments in the same sector or asset class.

How Tax-Loss Harvesting Fits Into a Tax-Efficient Investing Strategy

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Tax-loss harvesting is one piece of a broader tax-efficient investment strategy designed to minimize taxes and maximize after-tax returns. Other strategies include:

• Holding investments long-term to take advantage of lower long-term capital gains tax rates.
• Placing tax-inefficient investments (such as bonds or actively managed funds) in tax-advantaged accounts.
• Using tax-efficient funds such as ETFs that generate fewer taxable events.

By incorporating tax-loss harvesting into a well-rounded investment plan, investors can build a portfolio that is both tax-efficient and growth-oriented.

Reduce Tax Liability with Tax-Loss Harvesting

A tax-loss harvesting strategy is a powerful tool for reducing tax liability and keeping more of your investment returns. By strategically selling underperforming assets and reinvesting wisely, investors can optimize their tax position while maintaining a strong portfolio.

FAQs

When should I use tax-loss harvesting?

Tax-loss harvesting is most effective when you have realized capital gains in a given year or want to reduce taxable income.

Can I use tax-loss harvesting in my 401(k) or IRA?

No, tax-loss harvesting applies only to taxable accounts. Retirement accounts already offer tax-deferred growth.

How much in losses can I deduct from my income?

Up to $3,000 per year can be deducted from ordinary income, with additional losses carried forward to future years.

What is the wash-sale rule, and how do I avoid it?

The wash-sale rule prevents repurchasing the same or a substantially identical investment within 30 days of selling it at a loss. Investors should reinvest in similar but not identical assets.

Does tax-loss harvesting impact my long-term investment strategy?

No, when done correctly, tax-loss harvesting allows investors to maintain their target asset allocation while reducing tax liability.