You have to pay taxes on investment gains once they become realized, or you actually receive the disbursed gain from the investment. On the flip side, if you sell an investment for a loss, you can deduct the loss up to $3,000 from your taxable income. If your loss is more than $3,000, you can rollover the losses to future years.
By doing this, you are “harvesting” a loss so you can offset both gains and income. Then you can purchase a similar investment to maintain your optimal asset allocation and diversified portfolio. If you are able to do this on a consistent basis, you can reduce ordinary income of up to $3,000 and still get your expected investment return.
Studies have shown that by utilizing tax loss harvesting on your investments every year, you can increase your after-tax returns by more than 1.29%. For a 500k portfolio, over 20 years that would be an additional $500k! The earlier you start using tax loss harvesting and the higher your tax bracket, the more beneficial it can be in the long-run.
The IRS allows tax loss harvesting however the investment you purchase right after you take the losses can’t be the same investment or something very similar unless you wait 30 days. This is known as the “wash sale” rule. This is to make sure investors don’t benefit from the deduction without truly disposing of the investment. Also it can’t be from another account under the same owner, a retirement account, or a spouse’s account.
The safest way is to avoid the “wash” is not to purchase anything within 30 days. However not being in the market for 30 days can hurt your portfolio performance. For individual stocks, you can’t buy the same one but you can buy one that is similar in size, industry, and country. For mutual funds, the IRS hasn’t given guidance on two funds that are identical, but to be safe you can purchase a fund that is highly correlated.
You can look for tax loss harvesting opportunities when you are rebalancing your portfolio, getting two great benefits with one move. However you want to make sure this is right for you. If you believe you will be making more money in the future, it is better to take gains now instead of losses since your tax rate will be higher. Also if your tax bracket now is low enough where capital gains are tax-free, then tax loss harvesting may not be appropriate for you.
Talk to a financial professional to make sure this is right for you and to avoid violating the wash sale rule.