You may have heard of the phrase “tax loss harvesting” in the context of sales of stocks or other investments, and wondered exactly what it means.  Tax loss harvesting generally refers to selling investments (i.e. capital assets) at a loss, specifically timing them so that they offset gains (both capital and ordinary) in the same tax year and therefore reduce your tax liability.  The following discussion hits on just some of the reasons why someone may want to harvest losses and in particular a few of the complex rules around executing this strategy.  However, it is important to consult your own tax and investment advisor to determine what may be the best fit for you.

There are few people who wouldn’t welcome the opportunity to reduce their taxes.  Tax loss harvesting is one way of doing this.  Generating a tax deductible loss is one reason why someone may be willing to sell a stock that is worth less than what they originally paid for it.  Many people hold on to a stock that has lost value because they keep hoping it will “come back.”  But, if you have some investments that you believe may have reached their peak value, and the tax liability associated with selling them has you hesitating, then maybe now is the time to look for some of those investments that have lost value since you originally purchased them and “harvest” those losses (i.e. sell the security to make the related loss tax deductible).  You can then use those harvested losses to offset the gain on the stock that you believe may have reached its peak, lowering your tax bill.

Many people think they can use this strategy and then return to the stock market to buy that loss stock back still holding onto hope that it will actually recover its value.  However, there are tax rules that prevent this type of re-investment.  They are called the “wash sale” rules.  These rules prevent one from deducting a loss on a stock, if the same or a substantially similar stock is purchased within 30 days before OR after the disposition that harvested the loss.  The harvested loss is “replanted” so to speak and  cannot be taken until the replacement stock has been sold.  It’s important to note that this rule can apply even if the replacement stock is purchased in a different account than it was originally owned, as long as both accounts are owned by the same person, and even if the re-purchase is in a nontaxable retirement account!

Another very valid reason someone might want to lower their taxable income would be to prevent a temporary increase in their Medicare Premiums (Income-Related Monthly Adjustment Amounts or IRMAA) caused by reaching certain modified adjusted gross income levels as shown on their income tax returns.  At certain levels of income (which includes both ordinary income and capital gains), Medicare premiums (those for Part B, which is regular medical doctor coverage and part D which is prescription coverage) increase.  For example, the monthly premium in 2022 for Part B of $170.10 would instead be $442.30 if a single person had modified adjusted gross income in 2020 of $142,000.  (Medicare looks back two tax years.)  If they had modified adjusted gross income of $141,999, just $1 lower, their premium would be reduced by just over $100 per month, so $1,200 per year.  When you only need to lower your taxable income by a few dollars to have such a significant impact on your health insurance premiums, harvesting capital losses may be an easy way to accomplish this goal.

However, it is important when harvesting capital losses from investments to lower one’s taxable income, that you consider all of the tax rules.  They are complicated and can, if not given appropriate consideration, reduce the effectiveness of your harvested losses in reducing your overall tax liability.  For example, how long you have owned your stocks matters.  Stocks held more than one year are considered long term and those held a year or less are short term.  Gains from long term sales are actually taxed at lower rates (0%, 15% or 20% depending on your total taxable income) than gains from short terms sales or ordinary income from items like wages, or from a business on the side.

So in the ideal world, it would be terrific if you could use long term losses against short term gains or ordinary income, and as a second choice, short term losses against ordinary income.   Unfortunately however, you don’t get to pick and choose what types of losses are allowed to offset what types of income.  The tax law requires first, that short term gains and losses are netted against each other, and then long term gains and losses are netted against each other.  And then if you have an excess short or long term loss, it can go against ordinary income, but only up to $3,000 per year.  Any excess loss then keeps its character as long or short term and carries over to the next tax year to be subject to the same ordering rules and $3,000 limit.

And finally, be careful not to let the tax tail wag the dog!  Your choices of which investments to sell at a loss should be consistent with your overall investment strategy, in addition to having a tax reducing result.  For example, when deciding what to sell, be sure to consider how diversified you will be after the sale, especially if you are looking at selling larger holdings and generating larger offsetting losses.  Consider the long term growth potential of the stock.  If you want to buy back in, keep in mind the wash sale rules described above.   Maybe you want to reduce your exposure to a particular industry.  A stock in that industry may make a good loss harvesting candidate.  Then use the proceeds to re-invest in another industry you view more favorably.

Tax loss harvesting is just one, albeit very complicated tool that can be used to achieve both tax and investment objectives.  Just be sure you don’t accomplish one objective at the cost of the other!  A quarterly investment review is critical to keeping your investment portfolio healthy-and as you get closer to year end, doing that review with an eye on ways to reduce your tax liability by harvesting some tax losses, is a healthy add.