How to use tax-loss harvesting to manage taxes

Tax-loss harvesting is a way to reduce taxes by selling an underperforming asset and using the loss to offset other gains. Think of it like this: You sell an investment that's underperforming and losing money. Then, you use that loss to reduce your taxable capital gains and potentially offset thousands of dollars of your ordinary income. Capital losses can offset capital gains.

When the markets (or an asset) are down, it’s a potential way to cut taxes and reduce a position that isn’t ideal. Selling an investment when it’s below the price you paid for it may not be an ideal scenario, but it provides a silver lining in a down market and could be a useful tool.

“Tax-loss harvesting is a mainstay when looking to manage taxes,” said Tom Weizenegger, a director of client portfolio construction & manager research at 1834, a division of Old National Bank. “Unfortunately, portfolio holdings do not always appreciate, and so it makes sense to utilize those losses within the context of a tax-minimization strategy.”

Some general guidelines.

When an asset is sold for less than what was paid initially, a realized loss occurs and can be subsequently used to offset realized gains in an investment account. This strategy can be implemented when a security loses favor and there is no intent to hold going forward. Alternatively, tax-loss harvesting is a tool often used as year-end approaches to reduce tax liability.

Short-term gains and losses are netted out against each other, as are long-term gains and losses. The resulting short- and long-term totals are then netted again to arrive at a final realized gain or loss in a given year. The taxpayer is responsible for paying taxes on outstanding realized gains during the year. If there are total net losses, $3,000 can be applied to taxable income and the remaining balance is carried forward to the next calendar year. Losses are never “lost” and can be held for years.

When reinvesting the proceeds from tax loss sales it is important to be cognizant of wash sale violations. These occur when a security is sold and then repurchased within 31 days of the sale date. Once this 31-day period has elapsed investors are free to purchase the same security again. Violators of this rule are no longer allowed to recognize the realized loss right away; this loss amount is added to the cost basis of the repurchased security. Wash sale rules apply to individual taxpayers and not only to specific accounts, so an investor cannot sell a security at a loss in their agency account and then repurchase it in their IRA within 31 days.