How tax-loss harvesting works for the average investor

Tax loss harvesting has long been a common year-end maneuver among wealthy, older investors in higher tax brackets. In simple terms, it’s a year-end purge of unprofitable stocks performed to offset the tax burden of any capital gains (profits from selling winning stocks) realized throughout the year.

Newer and younger investors, however, may not be familiar with the practice. But with the advent of fee-free investing and fractional share trading — now commonplace thanks to popular digital brokerages like Robinhood — more young retail investors are trading stocks, and as a result, having to contend with the tax implications of doing so.

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But can smaller-scale retail investors really benefit from this time-honored and IRS-approved accounting maneuver? And how exactly does tax-loss harvesting work? Here’s a simple breakdown for newer, younger investors and hobbyist stock traders.

What are capital gains and losses? How are they taxed?

When an investor buys a stock and it goes up in value, that’s a capital gain. If it goes down in value, that’s a capital loss. Only once a stock is sold, however, are capital gains or losses realized, and only realized capital gains and losses affect an investor’s tax burden.

Capital gains and losses come in two forms. Long-term capital gains and losses are those realized from the sale of assets that have been held for longer than a year, while short-term gains and losses are realized from the sale of assets that were held for less than one year.

Investors have to pay taxes on realized capital gains because they are a form of income. When it comes to paying Uncle Sam, short-term capital gains are taxed at the same marginal rate as ordinary income, whereas long-term capital gains are taxed at lower rates — 0% for people or couples that fall into the lowest bracket. See the tables at the bottom of this article for a full list of rates for 2023 and 2024.

What is tax-loss harvesting? How does it work?

Investors are more likely to sell winning stocks than losing ones, so for many, realized gains tend to exceed realized losses as the end of the year approaches. After all, most average investors tend to hold on to stocks that have lost value in the hopes that they’ll go back up eventually.

Tax loss harvesting is the practice of purposefully selling stocks that have declined in value — as painful as that might be — in order to offset your capital gains or ordinary income so that you pay less in taxes.

For instance, if an investor realizes $4,000 in capital gains, but purposefully sells losing stocks to the tune of $2,000 in capital losses before year-end, they will only be taxed on the $2,000 of their capital gains that weren’t offset by their losses.

Additionally, if an individual doesn’t have any realized capital gains, or if their losses exceed their gains, they can use their losses to offset up to $3,000 of their ordinary income. For an individual who sits right above the lower end of a particular tax bracket, a $3,000 reduction in taxable income could push them into a lower bracket and translate to a major discount on their tax bill.

If capital losses exceed $3,000 after gains are offset, the remainder of these losses can be carried over indefinitely to offset gains and income in future tax years at the filer’s discretion. This phenomenon is commonly known as capital loss carryover.

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Tax loss harvesting example

Let’s say Investor X, a recent college graduate, makes $47,000 per year at their job as a server at a restaurant, landing them in the $44,726 to $95,375 tax bracket, which is taxed at a marginal rate of 22%. Using money from an inheritance, they get into investing around the beginning of 2023, primarily buying individual stocks and cryptocurrencies.

They sell several well-performing stocks over the course of the year, pocketing capital gains to the tune of $2,000. Unfortunately, they also buy what they think is a promising cryptocurrency token called DolphinCoin near its peak in February, and it plummets in value shortly after, resulting in a $5,000 unrealized capital loss.

If Investor X holds onto their position in DolphinCoin, hoping it will go back up in value in the future, their $2,000 capital gain from selling stocks would be taxed at 22%, and their ordinary income would be taxed progressively, with everything above $44,726 being taxed at their marginal rate of 22%.

If this investor decides instead to liquidate their position in DolphinCoin for a $5,000 loss before year-end, however, they could use $2,000 of that loss to negate their $2,000 in realized capital gains (resulting in no capital gains tax) and use the remaining $3,000 of their loss to reduce their taxable ordinary income from $47,000 to $44,000, pushing them into a lower income tax bracket and lowering their marginal tax rate for the year to 12%.

What is the wash sale rule?

While tax-loss harvesting is an above-board practice, there are certain stipulations that must be observed to do it legally in the eyes of the IRS, including the wash sale rule.

As mentioned above, many investors like to hold onto struggling securities instead of realizing a loss, so some might be tempted to repurchase shares of a stock they sold at a loss (in order to offset their capital gains) soon after selling.

The wash sale rule states that an investor may not claim a realized capital loss on the sale of a security used to offset gains or income if they purchase that same security (or a substantially similar one) within 30 days before or after the sale. This includes buying derivative securities like options on the stocks sold for tax-loss harvesting or buying shares of an ETF that includes the stock or stocks in question.

This provision prevents investors from taking part in “performative” tax-loss harvesting in which they only “pretend” to realize a capital loss by selling shares of an unprofitable stock and then simply repurchasing them afterward to recreate the original composition of their portfolio.

What else do smaller-scale investors need to know about tax-loss harvesting?

• All realized losses must first be used to offset realized gains of the same type. This means that short-term losses must be used to offset short-term gains, and long-term losses must be used to offset long-term gains. Once gains of the same type have been offset, any remaining losses can be used to offset gains of the other type.
• Capital gains and losses are calculated based on the cost basis of the investment in question. The cost basis of an asset is its purchase price, including any associated fees (e.g., brokerage fees, sales loads, etc.). Capital gains and losses represent the difference between an asset’s cost basis and the proceeds received by an investor when they sell it.
• Current-year capital gains and losses can be recorded on Schedule D on Form 1040 of an investor’s tax return.
• If, after capital losses are used to offset all of a current tax year’s capital gains and $3,000 worth of ordinary income, any remaining losses can be carried forward and used to offset gains and income in future tax years. If an investor wants to carry losses forward, they must keep accurate records of their capital losses. The IRS provides a worksheet to help filers track and calculate their capital loss carryovers.

Is tax-loss harvesting worth it for the average investor?

Whether tax-loss harvesting is a good move for any individual investor really depends on their individual circumstances. For many lower-income investors, though, a high tax bill (especially one that is unexpected, as might be the case for a newer investor not used to paying taxes on realized capital gains) can be a bit of a hurdle, especially if expenses are high and savings are minimal. In cases like these, tax-loss harvesting can be a good way to maintain financial stability in the short term.

For others, who plan to reinvest the money they might save on their tax bill using this practice, the answer is a bit more complicated. An investor who wishes to keep their asset allocation about the same as it was before they sold their unprofitable stocks might be tempted to repurchase those same stocks after the 30-day wash sale period. By doing this, however, they are essentially taking a tax discount now on something they hope to sell later for a profit — at which point they will have to pay capital gains tax on the sale.

That being said, the market is unpredictable and volatile, and everyone invests for different reasons. Some investors might use their tax savings to buy shares of something totally different, cutting their losses on what they see as a failed bet and moving forward with a new investment strategy.

In other cases, such as a high-interest-rate environment during a bear market in stocks, it might make more sense to put the money saved on taxes into a high-yield online savings account or government bonds so as to secure a guaranteed return over a known period of time rather than reinvesting in individual stocks.
Whatever the case may be, it’s always a good idea to consult a financial professional when deciding whether or not tax-loss harvesting is the right decision for your current financial situation. While many average, working investors cannot afford to hire a personal financial advisor, some workplaces offer free financial advice resources through partnerships with third parties, and local libraries, nonprofits, and mutual aid organizations may also have free or low-cost financial advice resources available.

Tax brackets for short and long-term capital gains

Below are tables that list short and long-term capital gains tax rates by income tax bracket for tax years 2023 and 2024. 

Short-term capital gains tax rates by income 2023

Long-term capital gains tax rates by income 2023

Short-term capital gains tax rates by income 2024

Long-term capital gains tax rates by income 2024