We talk a lot about investing and growing your money at WealthUp. But, while it seems silly to point this out in a year that the S&P 500 has returned a stellar 25% … not every investment pans out. Sometimes you simply pick a dud and lose money. 

And that's OK.

For one, it happens to the best of us.

But also, there might just be a silver lining to buying stock that later drops in value.

The Tea

Many investors use a strategy known as "tax-loss harvesting" (often at the end of the year) to turn stock losses into tax breaks.

In a nutshell, tax-loss harvesting is the process of selling depreciated stock (fancy lingo for a stock that's gone down in value as opposed to rising and having "appreciated") for a loss so that you can use the loss to offset taxable capital gains for the year.

You might also be able to use some of the loss to lower the tax on wages, tips, and other "ordinary" income.

WealthUp Tip: Here are a few more year-end tips that can help you lower your 2024 tax bill.

Sounds good, right?

It sure can be … but think twice before diving head first into tax-loss harvesting.

The Take

Since there are special rules to follow and pitfalls to avoid, tax-loss harvesting must be done carefully and isn't always the best option in certain situations.

On the other hand, if you know what you're doing, tax-loss harvesting can be an ace up your sleeve when you're not so lucky at picking stocks.

Offsetting Capital Gains With Losses

If you're thinking about harvesting losses before the end of the year, the first thing you need to understand is how capital losses can be used to offset capital gains.

As you might already know, the federal capital gains tax is generally imposed on any gain from the sale of stock (or other capital assets). If you hold stock for more than one year, any gain from the sale of that stock is considered long-term capital gain. A short-term capital gain results from the sale stock you hold for one year or less.

WealthUp Tip: See how long-term capital gains are taxed at a lower rate than short-term capital gains.

The same general rules apply when you sell stock for a loss. So, whether you end up with a long-term capital loss or a short-term capital loss depends on how long you held the stock.

This is important because you have to follow a certain order when offsetting capital gains with capital losses, and that order is based on the distinction between long-term gains/losses and short-term gains/losses. 

Here's the order you must follow:

1. Offset short-term gains with short-term losses.
2. Offset long-term gains with long-term losses.
3. If there are any net losses of either variety, they can then be used to offset any gains remaining of the opposite type.

Deducting Capital Losses From Ordinary Income

If you have a net capital loss after following the process above, you can deduct up to $3,000 of it from your "ordinary" taxable income, such as wages, interest, retirement account distributions, and the like (up to $1,500 for a married person filing a separate return).

Anything over the $3,000 (or $1,500) limit can be carried forward and applied against gains or deducted from ordinary income in future years until it's all used.

WealthUp Tip: Check out the best retirement plans to take advantage of tax-deferred or tax-free capital gains.

How Tax-Loss Harvesting Works

Now that you know the benefits of offsetting and deducting capital losses, you can see how tax-loss harvesting works.

First, the situation must be ripe for the strategy. You need an investment portfolio that includes both stock that has increased in value and stock that has lost value. You also need to sell some of the appreciated stock to have a gain to offset, or have taxable ordinary income against which a deduction can be claimed—or both.

If these conditions exist, you can sell some of the depreciated stock before the end of the year to generate a capital loss. That loss can then be used to offset the gains from the sale of the appreciated stock. That, in turn, will lower the gains that are subject to the capital gains tax.

WealthUp Tip: Robo-advisors can help with tax-loss harvesting. See our list of the best robo-advisors available.

If you still have unused losses after offsetting gains, you can deduct up to $3,000 of the remaining losses from your "ordinary" income in the current year.

If you have more than $3,000 of net losses, the excess is carried over to future years. As a result, you can even use tax-loss harvesting to reduce the federal income taxes you expect to owe next year or even further down the road.

Beware the Wash Sale Rule

After selling stock for a loss, you might be tempted to immediately buy that stock again. That way, you can generate a loss that offsets your capital gain or can be deducted against ordinary income, and still own the stock you held before.

Unfortunately, the wash sale rule prevents you from buying back the stock right away. In fact, the rule prevents you from buying the same or "substantially similar" stock within either 30 days before or 30 days after you sell depreciated stock. If you violate the rule, you aren't allowed to offset capital gains or claim a deduction against ordinary income with losses from the sale of stock.

WealthUp Tip: Look no further for the best trading accounts for teens and other minors.

However, at least the disallowed loss will be added to the basis of the repurchased stock, which will reduce any capital gain when those shares are sold. In addition, the holding period for the original shares transfers to the repurchased stock. So, you might be able to sell the new stock in less than one year but still have it treated as a long-term capital gain and taxed at a lower rate.

When Tax-Loss Harvesting Might Not Be Worth It

Tax-loss harvesting isn't necessarily something you want to do all the time. There are certainly some situations when it might not work out so well, such as when…

1. The stock market is volatile. If the market is all over the place, the stock you sell could take off the very next day … and your tax savings are far less than the money you could have made by holding on to the stock.
2. You repurchase stock that later soars in value. If you wait 30 days and repurchase the stock you sold to generate a loss, the new stock will have a lower basis than the original shares you sold. As a result, you'll have a larger gain when the repurchased stock is eventually sold, and the taxes on that gain could outweigh that tax benefits of an offset or deduction against ordinary income.
3. The stock you sell hasn't depreciated enough. A recent study suggested that selling stock to generate losses generally isn't worthwhile unless the stock's value has dropped at least 5% to 10%.
4. Your income is low. If your income is low enough, you might not owe any tax on long-term capital gains (i.e., it's taxed at a 0% rate). If that's the case, there's no need to harvest losses to offset long-term capital gains.
5. Trading costs are high. Tax-loss harvesting isn't worth it if your trading costs exceed the expected tax benefits.

And, of course, there could be other situations where tax-loss harvesting can be detrimental to your bottom line. So, proceed with caution when attempting this maneuver … and don't assume this strategy (or any other financial move) is right for you just because there's a lot of internet chatter about it or it's being pushed by a broker.

Riley & Kyle

WealthUp

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