Automated tax loss harvesting: Is it right for you?

You know that feeling you get when you look at your paycheck and a huge chunk of it was taken out to pay Uncle Sam?

It’s not a good one.

You work hard to earn your paycheck, and it’s tough to see a big piece of that wiped away by taxes.

Now imagine that same feeling with your investments. Imagine finding a great stock and having it blow up in value, leaving you a nice hefty profit. Then tax time comes around and you have to pay capital gains tax.

Yep, selling a stock for profit will cost you if you’re using a standard, taxable investment account. Why do you think we love tax-advantaged retirement accounts so much? They let your investments grow tax-free for decades.

For taxable accounts, there’s another strategy for reducing your tax burden: Tax-loss harvesting.

Tax-loss harvesting is a strategy where you sell certain assets (stocks, bonds, mutual funds) that have lost value in order to offset capital gains on other investments, and reduce your overall tax liability at the end of the year. You “harvest” a loss when an asset loses value, then use that money to buy a different—but similar—asset so your portfolio remains diversified.

You can use tax-loss harvesting to offset capital gains that result from selling securities at a profit. You can also use tax-loss harvesting to offset up to $3,000 in non-investment income.

Tax-loss harvesting is a strategy that you only apply to taxable investment accounts. Tax-deferred retirement accounts like IRAs and 401(k)s grow deferred, so they aren’t subject to capital gains taxes.

Let’s say that you have $10,000 in capital gains on certain stocks and funds in a taxable investment account. In order to minimize the tax liability from those gains, you sell other assets that will generate a loss. If those losses total $5,000, it will cut your capital gains—and therefore your capital gains tax—in half. We’ll get into exactly how this works to your advantage in a little bit.

Tax-loss harvesting can be complicated if you try to do it manually. But it’s actually a very easy process when it’s done by computers. And since they have the computers that can do it, certain brokerage firms and investment platforms, like Wealthfront and Empower, offer tax-loss harvesting as a feature.

The primary purpose of tax-loss harvesting is to defer income taxes. That’s the process of delaying the payment of taxes many years into the future. This allows an investment portfolio to grow and compound at a faster rate than it would if the money to pay taxes were withdrawn from the portfolio every year that gains occurred. The benefit will be fully maximized if you can defer the liability until after you stop working when you will presumably be in a lower tax bracket.

As an example, let’s say that you have a mutual fund that continues to rise in value each year for the next 20 years. You offset capital gains distributions from the fund using tax-loss harvesting. At the end of the term, the fund has grown to four or five times your original investment—largely because you never had to pay tax on the annual gains.

This creates a kind of tax deferral that works something like a tax-sheltered retirement account, even though the money is in a taxable investment account.

Should you turn on tax-loss harvesting on your brokerage account? Here are six situations where it might be a good idea: 

If you have a company-sponsored 401(k) or your own Roth IRA, your earnings are not hit with a capital gains tax. That’s the whole point of those types of accounts. The government wants to motivate you to save for retirement by offering tax breaks.

But if you have any other type of investment account that is subject to capital gains taxes, such as a standard brokerage account, you’d be smart to consider using tax loss harvesting. When using an account that isn’t protected with tax breaks, you’ll be hit with the capital gains tax every time you sell a stock for a profit.

If you don’t know what you’re doing, this could cost you thousands of dollars over time.

Tax loss harvesting won’t benefit you if you’re a day trader. In fact, I don’t recommend that strategy at all—that’s just gambling, not investing.

If you’ve read our article on value investing, you’ll learn that it’s a proven strategy (and a smart one) to buy a stock, ETF, index fund, or mutual fund, and hold on to it.

If you sell a stock within a year of owning it and make a profit, it’s considered a short-term gain, and you’ll be taxed at your normal income tax rate (which is likely much higher than the capital gains tax—see #six below).

If you buy and hold, however, your stock purchase will fall into the long-term gains category. Selling a stock after holding it for at least a year qualifies it as a long-term gain, which is taxed at 15% for people in certain tax brackets.

This means it’ll be taxed as a capital gain. This also means you’ll benefit from tax-loss harvesting.

In addition, the longer your investment horizon, the greater the benefit of tax-loss harvesting. Thanks, compounding!

The easiest way to build wealth is to pay yourself first. This means automatic deposits into your investment account.

Every time you make a deposit into your taxable investment account and it’s invested, it’s considered a tax lot. A tax lot is a method of record-keeping that allows you to trace the date of a sale or purchase, the original value of the asset, and the size of the transaction for every stock you own.

This even works if you trade a certain stock multiple times. This is a more advanced record-keeping technique and is really aimed to hold off on realizing capital gains while recognizing losses earlier—which can ultimately reduce your taxes.

With every tax lot comes a new opportunity to benefit from tax-loss harvesting. The best thing about this is that, if you’re using a robo-advisor, it will all be handled automatically, so you don’t have to recall every deposit or investment you’ve ever made.

Now, this is really cool. If you were to do tax-loss harvesting the old-school way, you’d probably figure out your gains and losses at the end of the year. That’s not the case with robo-advisors.

They’ll do this automatically for you on a daily basis. So if the market drops and there’s an opportunity to benefit from tax loss harvesting, they’ll handle it for you. Even if the market later rebounds (which may reduce the benefit later in the year).

One of the ways automated TLH works is by selling one investment then buying a similar one right away.

Just as a reminder, you can’t sell an investment for a loss then buy it back and still reap the benefits of TLH. It’s against the law. Let me explain…

Under the Wash-Sale rule, you can’t buy the same stock or security (or any other ‘substantially identical’ stock or security) in any other account you own if you’ve sold it for a loss in the past 30 days. You also can’t have your spouse or employer buy it for you.

And it gets even stickier with diversified funds like ETFs and mutual funds—here the law unclear. Questions have arisen on whether it’s okay to sell an index fund at a loss and buy a similar one right back. I wouldn’t recommend it, but if you really need to—please consult a tax professional.

Keep in mind that “owning the stock” means just that, regardless of which account you own it in. So, for example, if you sell a stock at a loss from your brokerage with one firm, you can’t just go buy it in a different account with another.

Remember, this only applies to losses, not gains. There is a lot of fine print with this law, so be sure to check with a tax professional if you’re concerned.

This is yet another reason I suggest consolidating your accounts and simplifying your investment strategy. A robo-advisor would handle this for you automatically.

This is the big one. If you make more than a certain amount, you’re sure to benefit from tax-loss harvesting. But if make a certain amount or under depending on your situation, you pay 0% in long-term capital gains taxes. So there’s no reason to try to offset taxes on your gains by “harvesting” your losses. You’ll pay no taxes on those gains regardless!

If you fall into any of the following three categories in 2024, TLH will not be a benefit to you at all:

• Single or married filing separately, with taxable income no more than $47,025
• Married filing jointly, with taxable income no more than $89,250
• Head of household, with taxable income no more than $63,000

If your taxable income is even a penny more than those figures, based on your tax filing situation, you’ll be accountable for capital gains tax. Thus, you’ll benefit for tax loss harvesting.

Tax-loss harvesting is a great feature, but you shouldn’t make an investment decision based on taxes alone.

The other thing to consider is that most robo-advisors, if not all, include tax loss harvesting in their fees. So if you’re already using a robo-advisor, you should be getting this benefit at no cost.

Quite frankly, there are only two scenarios where I’d suggest you stay away from TLH:

• Your income is low enough to qualify for the 10% or 15% tax bracket
• You don’t want to pay the fee for a robo-advisor and would rather invest on your own

For the second point, check out our breakdown on the cost of robo-advisors. If you’ve decided not to use one and will instead invest with an index or target-date fund, you may not even need to worry about tax-loss harvesting (unless you want to try it the old-fashioned way and do it manually).

For everyone else, though, it’s a feature that should come with your robo-advisor and is highly recommended.

You could save tens of thousands of dollars in taxes over the course of your investment timeline. Especially if you start young and have a lengthy retirement horizon ahead of you.