One way to think of tax-loss harvesting is trimming a large oak tree. To spur new growth and improve the overall health of a tree, we simply cut off dead or dying branches. Your portfolio functions in much the same way. All your assets can be thought of as the oak tree. Cutting off dead weight can do wonders for its long-term performance. And that’s where tax-loss harvesting comes in.
In a nutshell, tax-loss harvesting involves selling those stocks, funds or assets that are currently showing a ‘paper’ loss in your portfolio. That may be difficult to do psychologically, but it makes a lot of sense for your overall portfolio. For example, if you own shares in the SPDR S&P 500 ETF (SPY) or Hershey (HSY) and are down around $1,000, you could sell SPY or HSY.
Why you would want to do that comes into play during the second piece of the equation. Investors are able to use those losses to offset realized gains in other securities. So, if you sold SPY and its $1,000 loss, you could offset a $1,000 gain in your Google position. By doing this, you lower your overall taxes this year.
Even better is that if your capital losses exceed the gains or if you have no capital gains in a year, $3,000 worth of those losses can be used to reduce your ordinary income. And if you lose more than $3,000 on a stock, the excess can be pushed into the future to offset capital gains and ordinary income later on.
Mutual fund investors are able to benefit in another way as well. Thanks to their structure as pooled investment vehicles, they distribute capital gains yearly. Those gains are taxed just as if you had sold your position and are taxed as ordinary income. Harvested losses can be used to offset these gains.