Tax-loss harvesting, once a savings strategy reserved for the super-rich, is now accessible to average investors without millions in investable assets. This form of tax-efficient investing offers the opportunity to save significantly on capital gains taxes.

Robo-advisors like Betterment provide opportunities for tax savings through automated, efficient investment strategies that leverage tax-loss harvesting.

What is Tax-Loss Harvesting?

Tax-loss harvesting is a semi-active investment technique that strategically sells and purchases investments to utilize capital losses to offset capital gains, thereby reducing capital gains tax.

Let’s look at an example to better understand how tax-loss harvesting works.

Over time, the value of your investments will fluctuate. While we always hope our investments will appreciate, performance often varies. Suppose your S&P 500 index fund performs exceptionally well, but your emerging markets fund does poorly. The S&P 500 investment increases by $5,000, while the emerging markets investment decreases by $1,000. If you sell both stocks today, you would realize $4,000 in capital gains since the loss in the emerging markets offsets your S&P 500 gains.

But what if you’re not ready to sell your investments? If you simply hold onto these investments, you might eventually see both your S&P 500 and emerging market investments increase. This is great for your bottom line but forfeits the opportunity to utilize the $1,000 capital loss from the emerging market investment to reduce taxes.

Through tax-loss harvesting, you can strategically sell investments to lock in capital losses and then repurchase investments, utilizing those losses to offset capital gains. Your robo-advisor might sell the emerging market fund and buy a new fund of similar value to lock in the $1,000 loss for the tax year. This can offset dividends and other investment profits, thereby reducing your tax bill for the year.

Taking losses now and reducing taxes is better due to the time value of money and your long-term investment portfolio goals.

What Changes Have Made Tax-Efficient Investing Accessible to Lower Net Worth Investors?

Tax-loss harvesting used to be a slow, manual process. Brokerage firms would assist high net worth investors with tax-loss harvesting transactions and strategies, but it made no sense for large investment firms to offer this service to clients with smaller portfolios because of the time required.

In recent years, the rise of robo-advisors has brought improved automation to investing for the masses. One of the largest robo-advisors is the industry pioneer, Betterment. Utilizing their tax-loss harvesting algorithms, robo-advisors like Betterment have removed the need for expertise and cost traditionally required to utilize tax-loss harvesting, enabling Betterment to offer tax-loss harvesting to every Betterment client—regardless of portfolio size.

With tax-loss harvesting no longer being a manual operation, any investor can leverage tax-loss harvesting to save money and improve their long-term investment outcomes.

Tax-Loss Harvesting FAQ:

What is a Tax-Loss Sale?

A tax-loss sale refers to the act of selling an investment to realize a tax loss. In a tax-loss sale, a new investment is purchased shortly after selling one to replace the investment in that particular asset class.

Recognizing the investment loss and being able to offset capital gains reduces taxes for the year.

Can You Use Short-Term Losses to Offset Long-Term Gains?

Short-term capital gains apply to investments held for less than a year, while long-term capital gains apply to investments held for more than a year. Short-term capital gains are taxed at a higher rate than long-term rates.

Tax losses are first used to offset gains of the same type (e.g., long-term losses offset long-term gains), then excess losses can be used to offset the other type of gain. The limit for carrying over to the other type of gain is $3,000 per year.

What Does Tax Gain Mean?

Tax gain refers to the taxable income from investments. Tax gains are applicable to capital gains you earn from stocks, bonds, and other investments. Tax gains can be offset with tax losses from regular investment activities or tax-loss harvesting.

Can You Use Capital Losses to Offset Dividend Income?

Capital losses can offset up to $3,000 of ordinary income per year after considering other investment gains and losses. This includes dividend income.

How Significant is Tax-Loss Harvesting?

Tax-loss harvesting is not a necessity for any portfolio or investor. However, if implemented correctly over time, it can easily save you thousands of dollars. Larger portfolios will see more significant benefits than smaller ones, but any investor can benefit from tax-loss harvesting.

Are There Downsides to Tax-Loss Harvesting?

Depending on your brokerage firm, tax-loss harvesting transactions may incur a trade fee of about $10 per trade. In this case, each tax-loss harvesting transaction might count as two trades, costing $20. In such scenarios, excessive trading could become costly, so ensure your brokerage firm does not charge fees for tax-loss harvesting transactions before signing up.

Additionally, the complexity of different capital gains tax rates may lead to errors or additional tax preparation costs. However, working with reputable brokerage firms and tax professionals can help mitigate these issues.