Tax loss harvesting, or TLH for short, is the act of selling an asset at a loss, then quickly replacing it with a similar one—primarily to offset taxes owed on capital gains or income.
In practice, it lowers your taxes now and increases them later. But don’t freak out, because the key takeaway of TLH is this:
TLH can take a portion of your taxable investing and effectively turn it into tax-deferred investing.
And tax-deferred investing, as we’ll quickly demonstrate, can do wonders for wealth-building.
Tax me now or tax me later
Take a dollar you would’ve otherwise paid in taxes today. Now invest it wisely.
Odds are, it’ll be worth a lot more in the long run, even taking away any taxes you eventually owe. Depending on how your tax situation shakes out over the years, tax-deferred investing can be like Uncle Sam giving you a nearly interest-free loan to invest.
This is in large part why tax-deferred accounts like traditional 401(k)s and IRAs come with restrictions. They’re reserved for retirement, namely, and their contributions are capped.
But tax loss harvesting opens an entirely new door for tax-deferred investing, along with a few other side benefits. For a few types of investors in particular, it offers tremendous upside.
Who TLH benefits the most
Let’s start with an important caveat: While TLH offers potential value for most investors, it can be a wash or actually increase your tax burden in certain cases.
But for now, let’s focus on three types of investors who can reap some of the biggest rewards from the strategy:
The high-income earner
Once you’ve offset all of your realized capital gains taxes for a given year, any leftover harvested losses can be used to offset taxes on up to $3,000 of ordinary income. So in the case of high earners, this means trading a high income tax rate for a relatively low long-term capital gains tax rate. The end result is both deferring and discounting your taxes.
The steady saver
Not only are recurring deposits a great way to start a savings habit, they also produce more harvesting opportunities. That’s because the older an investment, the less likely it drops below its initial purchase price (aka “cost basis”) and can be harvested at a loss. A steady drip of deposits, monthly for example, creates fresh crops of investments for harvesting in the near future.
The tax-smart philanthropist
A common misconception of tax loss harvesting is that it helps you avoid paying taxes altogether. Believe it or not, however, two scenarios exist in which you actually can cancel out your tax obligation:
- The first is when you donate shares to charity. As we mentioned earlier, selling and replacing shares as part of a harvest increases their future tax bill. It does this by lowering the shares’ cost basis, or the initial purchase price used to calculate capital gains. If you donate and replace these shares down the road, however, you reset their cost basis to a new, higher level. This effectively wipes out their entire tax bill(!) that had accrued to that point. In the eyes of the IRS, it’s like those capital gains never happened, and it’s one big reason why wealthy investors have long paired TLH with the practice of donating shares.
- The second scenario is posthumously. At that point, you won’t get a tax break, of course. But any individuals who you leave shares to will, because immediately after your death, the cost basis of your investments similarly “steps up” to their current market value.
Your harvest awaits
Historically-speaking, tax loss harvesting has been too time-intensive and costly to execute for all but the wealthiest of investors. But technology like ours and the low-cost trading of ETFs have made it a tax strategy for the masses.
If TLH is right for you, the sooner you open and start contributing to a taxable account, the sooner you can start giving a portion of your taxable investing an edge. If you already have a Betterment taxable account, here’s how to turn on tax loss harvesting.
