The idea of tax-loss harvesting is to purposely sell investments that have gone down in value so that you lose money. The reason? To save money on taxes! You might be wondering why you’d do that. After all, an investment that had decreased in value might rebound, but since you sold it—you’d to miss out. To address that, tax-loss harvesting is a two-step process. The first step is to sell losing investments. The second step is to buy a similar investment. That second step makes it likely that if the market for the old investment goes back up, you’ll still reap the rewards with your new investment.
Tax-loss harvesting example
If you invested $5,000 in an energy company last year but today it's worth $4,000, fret not: you can sell the investment, buy a similar security, and claim the $1,000 loss against any capital gains you make. There's one caveat though. Rather than invest in the exact same energy stock, you might have to invest in a competitor or an energy ETF.
When you practice tax-loss harvesting, you can't sell and buy the exact same investment. That's cheating! Buying a different investment in the same sector is one way of keeping skin in the game without breaking the government’s rules. There are other workarounds too, but they're better done algorithmically by a computer.
Pros of tax-loss harvesting
Aside from saving on your tax bill, tax-loss harvesting can increase your gains through the magic of compounding. That's because instead of sending money to the government today, you can keep it invested and earning money for you. Over a long enough period of time, the gains on the taxes you’ve deferred can be a big contributor to your returns.
Is there anything to be careful about?
Tax-loss harvesting is not possible in retirement accounts. These accounts are already tax-advantaged so you can't benefit from further tax reductions. As we mentioned earlier, you can't buy and sell the exact same investments; finding similar, but not identical, investments can be a little complicated if you choose to do it yourself. Since everyone's situation is unique, it's wise to consult a tax professional or financial advisor. Some investment platforms also do the tax-loss harvesting for you.
