What Is Tax Loss Harvesting and How Does it Work?

Tax loss harvesting is a type of portfolio rebalancing for tax efficiency purposes. Most people don’t perform tax loss harvesting manually. Instead, their broker does it automatically. While the process is automated, there are still some areas to look out for, such as the wash sale. Let’s go over how it all works.

What Is Tax Loss Harvesting?

When a stock is sold at a loss, matching it with a stock that has a gain can decrease the loss. This loss reduces the taxable gain. There is no taxable gain if the transaction results in a net loss (i.e., excess loss). The proceeds from these sales are used to rebalance the portfolio back to its intended allocations.

Let’s look at some examples to see how tax loss harvesting works. Both examples are short-term gains and different stocks. 

Transaction 1:

Sell Stock A and realize a $10,000 loss.

Sell Stock B and realize a $9,000 gain.

The net transaction results in a $1,000 loss. The investor has $2,000 remaining of the $3,000 limit for annual losses.

Transaction 2:

Sell Stock A and realize a $10,000 loss.

Sell Stock B and realize a $15,000 gain.

The net transaction results in a $5,000 gain vs. a $15,000. Using a simple calculation on a 35% marginal tax bracket, tax savings are $3,500:

$15,000 x 0.35 = $5,250

$5,000 x .25 = $1,250

$5,250 - $1,250 = $4000

If the net loss is large, the IRS will allow up to $3,000 in losses during a year. The investor can carry anything over that amount into the next year. 

Immediate losses must be matched. Meaning, short-term losses must be matched against short-term gains and the same for matching long-term gains. However, if you have an excess loss in one category (short or long-term), it can be applied to the other type of gain.

Tax loss harvesting is only available in taxable brokerage accounts, not 401(k)s or IRAs.

Be Aware of the Wash Sale Rule

The Wash Sale Rule states that you can’t buy the same or substantially similar security 30 days before or after selling a position. The sold security and the one being purchased must be different. A wash sale can delay your ability to claim a loss on the position being sold.

A wash sale can also occur if your spouse or a company controlled by you buys a substantially similar position from the one you sold.

Automated Tax Loss Harvesting

Keeping track of tax loss harvesting and making the necessary trades can be time-consuming and tedious. The good news is that you don’t have to. Most brokerages will manage tax loss harvesting for you. It is usually a feature that you have to enable.

Beware that a broker’s automated tax loss harvesting can only view your investments at that brokerage. It can’t see the investments you have with other brokers. This means you might trigger a wash sale if you’re not careful. That can happen when Stock A is sold at Brokerage A and Stock A is bought at Brokerage B.

When using tax loss harvesting, it is best to work with a tax advisor who can keep track of trades across your various brokerage accounts and monitor tax loss harvesting activity.