Is Tax-Loss Harvesting a Good Idea? 

Couple doing taxes|

When your portfolio — or even just a portion of it — is down, many people look away and tell themselves that the market will come back up eventually. And while ignoring the urge to completely overhaul your portfolio during a down market will probably result in higher returns in the long run, a bit of tax optimization via tax-loss harvesting could boost your returns even more. 

Although simple conceptually, tax-loss harvesting can have multiple implications for your tax and investing situation. Learn what tax-loss harvesting is as well as its benefits and drawbacks. 

What Is Tax-Loss Harvesting? 

Tax-loss harvesting is the act of selling — or “harvesting” — a position or multiple positions in your investment portfolio for a loss, typically for the purpose of “reaping” tax benefits from the losses generated. 

The sale of an investment at a loss will typically be characterized as a capital loss for tax purposes, meaning that the loss is subject to special tax rules that do not apply to other kinds of losses, such as ordinary losses. 

Nevertheless, capital losses — such as those generated by tax-loss harvesting — can potentially produce two major tax benefits, depending on the taxpayer’s situation: 

  • Capital losses can offset capital gains during the year, thereby potentially reducing the taxpayer’s capital gains tax for the year. 
  • If capital losses have completely offset the taxpayer’s capital gains for the year, the taxpayer can deduct $3,000 ($1,500 for a married person filing their taxes separately from their spouse) of the excess capital losses against their ordinary income with any remaining capital losses carried forward indefinitely to future tax years until they are used up. 

Note that capital losses within tax-advantaged accounts such as IRAs do not produce tax benefits since losses in these accounts do not flow to their account owner’s tax return. 

This means that tax-loss harvesting is not possible to do in tax-advantaged accounts; it is only a viable strategy within taxable accounts. 

Pros of Tax-Loss Harvesting 

Here are the major reasons that tax-loss harvesting can be beneficial. 

Direct Tax Benefits 

The most obvious pro of tax-loss harvesting is the tax benefits that can be directly attributed to the capital losses themselves, namely, a reduction in one’s capital gains tax liability and a reduction — up to $3,000 — of one’s ordinary income subject to regular income tax rates. 

Qualification for Other Tax Benefits 

Apart from the obvious tax benefits of tax-loss harvesting, the technique can also improve a taxpayer’s tax situation by reducing their income so they can qualify for other tax benefits not directly associated with the capital loss itself. 

For example, let’s say that, absent any tax-loss harvesting, a taxpayer’s adjusted gross income is slightly above the threshold amount to take — or maximize — the retirement savers tax credit. 

However, by utilizing tax-loss harvesting, this taxpayer may be able to reduce their adjusted gross income to below this threshold amount, thereby generating an additional tax benefit. 

These tax savings could, theoretically, be reinvested back into their portfolio and earn a return, thus compounding their total investment returns. 

An Incentive for Cutting Losses 

Knowing that they will be able to reap some cash benefit — via lower taxes — from selling this investment could provide the psychological push an investor needs to take action and eliminate this investment from their holdings. 

Although investors should tread carefully when selling investments when they are down, the fact remains that not all investments are good ones. A taxpayer may very well have an investment in their portfolio that needs to be culled. 

Three Cons of Tax-Loss Harvesting 

No tax strategy is without drawbacks, and tax-loss harvesting is no different. Here are some cons of this popular tax technique. 

Foregoing Future Losses 

Taking capital losses this tax year means that they won’t be available in future tax years to offset your future capital gains and ordinary income. 

If you believe you will be in lower tax brackets in the future, this isn’t a bad thing — you’d rather take the loss now at a higher tax rate. 

But if “future you” makes more money or lives in a higher-tax-rate environment, then engaging in tax-loss harvesting this year will result in you taking a lower tax benefit now at the loss of a greater tax benefit later

Of course, the benefit of investing and earning a return on your current tax savings as a result of tax-loss harvesting could outweigh the loss of these hypothetical future tax savings. 

Potentially Unsuitable Allocation Adjustment 

Any qualified financial advisor will tell you the importance of asset allocation within your portfolio. 

A 100%-stock portfolio may be appropriate for a fresh college graduate, while those approaching retirement may need to consider more fixed-income securities in their portfolio. 

And even within the stock portion of one’s portfolio, it may be advisable to consider one’s allocation among different sectors such as energy, financials, consumer staples, and technology. 

But suppose you “let the tax tail wag the dog,” so to speak, and prioritize the tax benefits gained by tax-loss harvesting at the expense of proper asset allocation. In that case, the results could be disastrous to your long-term investment and retirement strategy

An incentive for Cutting One’s Losses Too Soon 

Just as tax-loss harvesting could provide the push an investor needs to cut off losing investments from their portfolio, it could also tempt them to give up on an investment on the brink of recovery. 

For example, a confidential purchase agreement may be in the works that, when made public, could send the share prices rocketing. Or the company could be months away from announcing a major new product line that will boost revenues and profits. Even more inexplicably (and unlikely), the company could become the next meme stock. 

No one knows the future, and like all investing and tax strategies, tax-loss harvesting involves risk. However, by learning about the basics of this common tax strategy, its benefits, and its drawbacks, you can decide what’s right for your situation. 

Find out how to use your home equity to live your best life

Learn More
CTA Image