What to know about tax loss harvesting

While you hope that your investments will rise in value, you may have a position or two that suffers a loss even in the most bullish markets. But did you know that those losses could help lower your taxes and potentially rebalance your portfolio for the year to come?

Here's what you need to know about tax-loss harvesting and how it could help you lower your risk and decrease your taxes.

What is tax-loss harvesting?

Tax-loss harvesting is the practice of selling investments at a loss to offset capital gains taxes incurred by selling other investments at a profit. Your upside is that you only pay taxes on your net profit, which is the final amount of realized gain after subtracting your loss from your gain. A strategy executed at the end of calendar year, the goal of tax-loss harvesting is to reduce or eliminate your capital gains tax liability.

Tax professionals can use tax-loss harvesting to reduce your exposure to costly short-term capital gains taxes, which are taxed as ordinary income1 at rates up to 37%. Here's what that looks like in practice:

Say you invested $10,000 in a tech stock in January that rose to $14,000 in value by June and then sold that stock. That $4,000 gain that would be subject to short-term capital gains taxes. You may also have a healthcare stock that's lost $2,700 in value sitting in your portfolio. With tax-loss harvesting, you'd sell the healthcare stock and then subtract the $2,700 loss from your $4,000 gain. Now, your net profit is only $1,300, which reduces your tax liability.

How can tax-loss harvesting help beyond taxes?

Unrealized gains and losses can open you up to risk you never planned on taking. Tax-loss harvesting can also help you keep your asset allocation dialed into your risk tolerance and goals.

In the example above, you could leave yourself open to unnecessary risk if your portfolio is overweighted in tech and underweighted in industrials. With tax-loss harvesting, you could also sell enough of both stocks (winners and losers) to bring your tech allocation back in-line with your target asset allocation and use the sale proceeds to reinvest in other holdings that align with your target asset allocation.

It's important to note that if you sell a stock and then rebuy that same stock within 30 days, that's called a wash sale. You won't be able to claim the initial loss on your taxes.