Harvesting Tax Losses to Beat Capital Gains

Dan Pascone |

Tax loss harvesting is a term that sounds like it should be buried deep in a CPA textbook, but it’s actually a very straightforward strategy every tech professional should have in their arsenal. 

It’s the financial equivalent of turning lemons into lemonade. 

When the market gives you a downturn, tax loss harvesting allows you to sell those underperforming assets to strategically lower your tax bill.

Now, it’s not like you’re playing with house money in the casino– a loss is still a loss. Few are intentionally trying to lose money to avoid paying taxes. 

Still, tax loss harvesting allows you to sell off some of your losing holdings to offset the gains of your winners. 

Whether those gains are short-term (which get taxed more heavily) or long-term, your realized losses can step in as a tax shield. 

Here’s the skinny:

  1. The IRS allows up to $3,000 of capital loss against your ordinary income (salaries, wages, rental income, etc) per year.
  2. Most people circle December 31st on their calendars as the final day to make these moves every tax year. However, this strategy isn't confined to just being a year-end ritual; it’s a year-round opportunity to fine-tune your portfolio's tax efficiency.
  3. Be mindful of limitations like the “wash sale rule,” which prevents you from buying a “substantially identical” security within 30 days before or after the loss trade date.
  4. Tax-loss harvesting is a strategy exclusively for taxable accounts. It's not applicable to tax-advantaged retirement accounts, such as 401(k)s and IRAs, or 529 college savings plans. 

Whether you're day trading on the side or you’re sitting on a few long-term holding duds, tax loss harvesting can play a key role in reducing what you owe to Uncle Sam so you can keep more of your money working for you.

By the end of this article, you'll understand how tax loss harvesting works and why it's crucial for everyone from entry-level employees to high-earners. 

Let's dive deeper into how tax loss harvesting can be a game-changer for your financial strategy.

Tax Loss Harvesting for High-Earners 101: What Exactly Is Tax Loss Harvesting?

Tax loss harvesting (noun): The act of strategically selling off underperforming investments to gain a tax advantage. In doing so, unrealized losses– investments that have dipped below their purchase price—into a strategic offset against your realized gains or taxable income. 

Why should you care?  In an industry where capital gains can come from various sources—be it stock options, startup equity, index funds, your casual Robinhood trading, or even cryptocurrency—understanding how to navigate your tax obligations safeguards your wealth and empowers you to reinvest in your lifestyle, your next venture, and your financial independence.

Capital gains are the profit you make from investments realized upon selling them for a higher price than you bought them for. They’re taxed at two different tiers– short-term and long-term.

The Tax Loss Harvesting Basics:

Let’s say you’re sitting on $5,000 of unrealized losses without any realized capital gains this year.

For example, you haven’t sold your winning stocks (thus not incurring capital gains tax) but have stocks that are currently down $5,000.

The IRS caps your loss-harvesting deductions from ordinary income at $3,000 annually for individuals or those married and filing jointly. 

So, if your losses total $5,000, you can deduct $3,000 this year. If you have any capital gains incurred from selling assets at a profit, you can offset up to $2,000 of the profit. 

Alternatively, if you have no capital gains, you can carry forward the remaining $2,000 for future deductions against ordinary income or offsetting capital gains. 

Tax Loss Harvesting Limitations

You should be aware of the infamous wash sale rule, which says you can't claim a loss on a security and then turn around and buy a "substantially identical" one within 30 days before or after the sale in any account.

So, in theory, let’s say you sell $5,000 of TSLA stock in which you have an unrealized loss and buy back $5,000 of TSLA the next day. According to the wash sale rule, you can’t claim the loss.

It’s not goodbye forever; it’s goodbye for now.

But here's a wrinkle: the IRS hasn't laid out what "substantially identical" means in black and white, sparking debates among investors. However, you can sidestep this gray area by choosing funds that track different indexes to maintain similar market exposure.

The rule is a bit of a dance, applying to all your investment accounts and even to reinvested dividends and capital gains.

So, if you're eyeing those losses to lower your tax hit, you'll need to pause any automatic reinvestments into the same stock post-sale.

That’s why it’s helpful to speak to a licensed financial planner.

Considering diving back into the market post-harvest? 

You have two choices: snag a different fund right away or sit on your hands with cash for 31 days before jumping back into your original investment. 

The first option might be smarter because missing just a few of the market's best days each year could impact your annual returns.

Alternatively, you could throw that money into a high-yield savings account, earning about a month’s worth of APY before reinvesting into the market. 

A Tax Loss Harvesting Case Study: 

Let’s say Zach is sitting on $20,000 in unrealized losses accumulated over the past 3 years. Here’s how he can apply tax loss harvesting to claim these losses against his capital gains and income. 

#1. Offset Capital Gains: First, he can use his losses to offset any capital gains dollar for dollar. Let’s say he’s got $10,000 in capital gains; he can use $10,000 of his $20,000 losses to bring his taxable capital gains down to zero.

#2: Deduct from Ordinary Income: If Zach has offset all his capital gains, or if he had no gains to offset, he can deduct up to $3,000 of his remaining losses from his ordinary income if he’s single or married, filing jointly. If he’s married and filing separately, the limit is $1,500.

Remember, ordinary income refers to earnings that are subject to standard income tax rates, as opposed to earnings that benefit from special tax treatment, like capital gains. This includes wages, salaries, commissions, bonuses, and income from business activities in which you actively participate, as well as interest, dividends, rental income, and pension or retirement plan distributions. 

Essentially, ordinary income is what most people consider their regular earnings, taxed according to the IRS's income tax brackets.

So, let’s say Zach’s marginal tax rate is 30%. By lowering his ordinary income by $3,000, he’d effectively save $900 that would otherwise go to Uncle Sam. 

It doesn’t exactly erase the $3,000 loss, but it’s something! 

#3 Carry Forward Remaining Losses: After offsetting his capital gains and deducting the allowable amount of $3,000 from his income, any remaining losses can be carried forward to future tax years indefinitely. 

In Zach’s case, after offsetting $10,000 of his potential capital gains and deducting $3,000 from his income, he would have $7,000 remaining ($20,000 - $13,000) he can carry forward to offset future gains or deduct in subsequent years.

These remaining losses can be carried forward indefinitely, either offsetting capital gains 1:1, or deducting up to $3,000 from ordinary income. 

So, let’s say Zach has another $10,000 in capital gains the following year. He could apply his remaining $7,000 of losses to bring his capital gains to $3,000, on which he’d owe the capital gains tax appropriate for the duration of his holdings (short-term for under a year, long-term for over a year.)

How to Tax Loss Harvest

Here’s how to effectively tax loss harvest: 

  1. Disable Dividend Reinvestment and automated DCA programs to ensure your automatic reinvestments don't interfere with your strategy, especially in relation to the wash sale rule.
  2. Review your recent purchases and confirm that you haven't acquired any shares of the investment you're considering for tax loss harvesting within the last 30 days to avoid triggering a wash sale. This usually happens through automated reinvesting programs, so check any automations you may have in place.  
  3. Sell the loss-making position to realize the loss for tax purposes.
  4. Invest in a different fund that isn’t “substantially identical” to maintain your market exposure, or just hold the proceeds in a savings account for 31 days before reinvesting in the original security.
  5. Once you've navigated the 30-day wash sale window, you can turn dividend reinvestment back on on the 31st day or re-purchase the stock– unless, of course, you plan to do more harvesting with the same asset. 

Tailoring Tax Loss Harvesting for High-Earners: Unique Considerations:

With higher income brackets comes higher taxation. 

As of writing, the maximum capital gains taxes are 20% for long-term gains and up to 37% for short-term gains. 

This why it’s worth even just adding a calendar notification in December to remind you to implement tax loss harvesting. 
(pro tip: copy and paste a link to this article in the invite if you want to reference it again.)

While the $3,000 deduction against ordinary income might seem minimal for a high-earner, the real value is in offsetting capital gains. 

By reducing your capital gains, you're saving on taxes this year and potentially lowering your future tax burden by strategically choosing which assets to sell at a loss.

The ability to carry forward losses indefinitely means you can strategize your tax loss harvesting to align with your financial goals and expected income fluctuations. 

For instance, if you anticipate a significant income spike or a large capital gain in the future, your carried-forward losses can become a critical tool in managing your tax liabilities.

Let’s say you have $50,000 in unrealized losses in various individual stocks, but you’re convinced those stocks will be worth much more in the future. 

You could sell those stocks, claiming a $50,000 loss, which can offset your future capital gains (or up to $3,000 in ordinary income per year). 

Then, 31 days later, you can buy those stocks back. 

When it’s all said and done, your portfolio still has the same stocks, but you have a $50,000 tax advantage a la tax harvesting. 

However, keep in mind that the price at which you re-buy your stocks will be your new cost-basis, meaning you may have higher capital gains tax should they increase in price. 

Check out our tax harvesting new cost-basis example in our capital gains guide.

Tax loss harvesting at higher tax brackets can be pretty nuanced, making it imperative to discuss it with a licensed financial planner.

High-earners should explore tax loss harvesting as just one piece of their broader financial plan, and understand how these strategies impact estate, investment, and retirement planning. 

Making Cents of Tax Loss Harvesting

Here's what we've unpacked about tax loss harvesting: it's a powerful tool that can help you save on taxes, especially if you're earning a lot.

To Make Cents of it all, tax loss harvesting helps turn your losses into wins. It’s like making the best out of a bad situation.

You can lower your tax bill this year by selling investments currently down and re-purchase the same assets in 31 days. 

It’s a potent tool for high-earners with an income taxed at a higher rate and for folks realizing significant capital gains yearly. Keep an eye on your investments all year round to grab any chance to reduce taxes.

You must ensure you follow the IRS's rules, especially the wash sale, to ensure your tax loss harvesting counts. 

You can use your losses indefinitely into the future; you can get creative in planning for future potential windfalls, such as an equity liquidity event. 

A tax professional can help provide personalized advice and ensure you maximize your tax loss harvesting benefits within the IRS guidelines.