While investors prefer to have their investments increase in value over time, sometimes an investment that has lost value can produce some good in the form of possible tax savings. The strategy that allows an investor to utilize a realized loss upon the sale of an investment to offset a realized gain upon the sale of another investment is called “tax loss harvesting.” This column discusses “tax loss harvesting” and how “tax loss harvesting” may help an individual investor reduce taxes now and in the future.
The strategy of “tax loss harvesting” is applied to investments held in non-retirement brokerage accounts only. It cannot be applied to investments held in retirement accounts (such as qualified retirement accounts – for example, 401(k) and 403(b) retirement plans, the Thrift Savings Plan, and IRAs including both traditional IRAs and Roth IRAs).
Understanding an investment (capital) loss
When an individual investor owns an investment (capital) asset (for example, a stock, a bond, an open-end fund, a closed-end fund, or an exchange-traded fund) and the investment asset’s current value is less than its “cost basis” (in general, what the individual paid for the asset plus any reinvested dividends and capital gains) the individual has a “realized” loss. If the individual were to sell the investment asset, then the individual has a “recognized” loss,” known as a capital loss.
A capital loss can be utilized in a particular year to avoid paying capital gains taxes in the following way:
- The capital loss is used to offset a capital gain dollar-for-dollar, and
- After all capital gains have been offset, any remaining capital losses can offset up to $3,000 of other (ordinary) income (such as wage income, interest income, and pension income) on a federal income tax return. This limit is $1,500 for a married individual filing separately.
- Thereafter, any unused capital losses can be carried forward to the next year(s) to be used to offset capital gains in future years.
During a year in which the stock market is volatile (such as was experienced during 2023) “tax loss harvesting” can be advantageous for an individual investor. Capital losses can be put into what is called a “tax savings account” and potentially used to offset capital gains for several years.
While “tax loss harvesting” appears to be an advantageous strategy to use in order to save on current year and perhaps future year taxes, there are some important details an individual investor should be aware of. These details are now presented.
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Short-term versus long-term capital gains and losses
There are two types of capital gains and capital losses; namely, “short-term” and “long-term.” Short-term capital gains and capital losses are those realized from the sale of a capital asset that an investor has owned for one year or less. Long-term capital gains and capital losses are those realized from the sale of a capital asset that an investor has owned for more than one year – at least one year and one day.
When it comes to the short-term and long-term capital gains, the key difference is the percentage rate at which they are taxed.
- Short-term capital gains are taxed at the investor’s marginal tax rate as “ordinary income.” The 2024 marginal tax rates are 10 %, 12%, 22%, 24%, 32%, 35% and 37%. For those investors subject to the net investment income tax (NITT), there is an additional 3.8% tax imposed on the investor’s marginal tax on both short-term and long-term capital gains This means that an investor who is in a 37% marginal tax bracket and who is subject to the NITT will be subject to a total 40.8% tax on short-term capital gains.
- Long-term capital gains “preferential” tax rate applies, as shown in the following table:
| Marginal tax bracket | Long-term capital gain tax rate |
| 37% | 20% |
| 22%, 24%, 32%,35% | 15% |
| 10% and 12% | 0% |
Capital gains in “open-end” (mutual) funds
An “open-end” (mutual) fund investor may receive long-term capital gains in the form of a capital gain distribution. “Harvested” capital losses can be used to offset a fund’s capital gain distribution.
Using “harvested” capital losses to help enhance tax savings
An individual investor looking for investment “selling candidates” that will possibly generate capital losses is advised to consider selling those investment assets that no longer fit within the individual investor’s financial goals. Also, “selling candidates” should have a poor prospect for future growth or can be easily replaced by other investment assets that are more likely to accomplish the investor’s financial goals.
In looking for possible capital losses, an investor is advised to focus on short-term capital losses. Short-term capital losses most probably provide the greatest tax benefit because they are first used to offset short-term capital gains. Short-term capital gains are taxed at the higher marginal tax rate and not at the lower preferential long-term capital tax rate, as shown in the table above.
In accordance with IRS rules, short-term and long-term capital losses are used first to offset capital gains of the same type. However, if capital losses of one type exceed the capital gains of the same type, then an individual can apply the excess losses to the other type. The following example illustrates:
Shawn sells a long-term investment at a $18,000 loss but Shawn only had $10,000 in long-term capital gains for the year. Shawn can apply the remaining $8,000 excess long-term capital losses to offset any short-term gains.*
*This is a hypothetical example for illustration purpose only and does not represent an actual investment.
Those investors who have harvested short-term capital losses but have unrealized long-term capital gains may want to consider realizing those capital gains in the future. Because long-term capital gains are subject to preferential tax rates, realized short-term capital losses (which are most effectively used to offset short-term capital gains subject to ordinary tax rates) are most effectively used to offset short-term capital gains in the future. In short, the least effective use of harvested short-term capital losses is to apply them to long-term capital gains.
Other IRS rules with respect to “tax loss harvesting”
- If an individual has at the end of the year any net capital losses, those losses can be applied (up to a maximum of $3,000 per year) against other income (such as salary, interest, retirement income, or rental income). For individuals filing as married filing separate, the limit is $1,500. Any excess capital losses above $3,000 can be carried forward and used in future years.
- Losses from the sale of personal property (such as a personal residence, tools, jewelry, cars or trucks) are not deductible. But capital gains resulting from the sale of personal property are fully taxable.
- Investors should be aware of the “wash sale” rules. A “wash sale” occurs when an investor sells an investment asset at a loss and then buys the identical or a substantially identical investment asset within 30 days before or after the sale. Under IRS rules, the investor cannot use the capital loss to offset capital gains or to apply the capital loss against other income. The amount of the disallowed capital loss is added to the cost basis of the repurchased investment asset. More information on “wash sales” can be found in IRS Publication 550 (Investment Income and Expenses).
Finally, it is important for investors to note the saying: “Do not let the tax tail wag the investment dog.” Individual investors are advised not to use tax savings via “tax-loss harvesting” to undermine the importance of their financial goals and a sound investment strategy. They are also advised to work with a tax professional when utilizing “tax loss harvesting.”
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Ed Zurndorfer, EA, ATA, CFP®, CLU®, ChFC®, CEBS®, ChFEBC℠: Federal Employee Benefits Expert
A former career Federal employee, Ed has published a staggering 1,200+ separate articles on Federal Benefits and Retirement!
Just “Google” his name, and you are likely to find a plethora of sites that contain his writings. Drawn to its mission to reach, teach
and serve Feds, Serving Those Who Serve is the only financial planning practice with which Ed has chosen to affiliate in over
20 years teaching. In addition to conducting Federal Benefits seminars for Serving Those Who Serve, you can find Ed’s
writings here on our blog in the FedZone, and on Fed-Soup, MyFederalRetirement, FederalNews Radio and NITP.
He is a member of the Maryland Society of Accountants, the National Association of Enrolled Agents, the International Society of Certified Employee Benefits Specialists, the Financial Planning Association, the National Association of Health Underwriters,
and the Society of Financial Service Professionals. Since 1999, Ed has taught many thousands of Federal employees about
their benefits, in person and at Federal agencies all over the country. Ed is a true national treasure.
Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street - Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.