Taking investment losses doesn’t feel good, but done right, it can lower your tax bill and boost after-tax returns.
Tax-loss harvesting is the wonky term for a strategy that lets you use losses to offset taxes on capital gains owed when you sell at a profit. Those investment losses can offset gains not just from other securities, but from gains on the sale of a home or business.
Even with the S&P 500 up more than 20% in 2023, investors can still use this strategy, according to Mary Lukic, head of tax-advantaged equity at Northern Trust Asset Management.
“We see plenty of opportunity to lock in losses before yearend,” she said. More than a third of S&P 500 securities are in the red.
Not only can losses help manage capital gains, they may be used to offset ordinary income. If you have losses but no capital gains, or have net losses even after offsetting capital gains, some of those losses can be deducted against ordinary income, up to $3,000 a year. Losses you don't use in one year can be carried forward indefinitely for future use as well.
“We think of this as a year-round strategy,” said Monali Vora, head of wealth investment solutions at Goldman Sachs Asset Management. “You can do it almost every month, subject to the market.”
Vora and Lukic both said that tax-loss harvesting can add between 1% to 2% to after-tax returns annually.
How It Works
Depending on how long you’ve held a stock, capital gains taxes can be pretty painful.
Tax on long-term gains—positions held for more than a year—is either 0%, 15% or 20%, depending on your taxable income and filing status. Positions held for a year or less, however, are taxed as ordinary income. For top earners, that’s a 37% federal rate, and capital gains taxes in high-tax states such as New Jersey, New York and California can push the rate to around 50%.
Moreover, tax-loss harvesting is more than just selling losers to offset gains. The idea is to sell losers and then replace them with holdings that keep your portfolio with the same overall composition—the same exposure to certain industries, or in line with any benchmark index your portfolio is meant to track.
That can be a little tricky. Investors aren’t allowed to take a taxable loss in a security, and then just buy that position right back.
The so-called “wash-sale” rule requires that the same security, or what the IRS calls “a substantially similar” security, not be bought within 30 days before or after the sale. Spouses can’t buy that same or similar security for their portfolio during that period, either.
An example that would be allowed, however, is replacing a position in Moderna Inc.—which is down about 50% this year—with shares of Pfizer Inc. to maintain a similar stake in health-care companies.