People usually invest to gain profit after some time, but it doesn't always have to be true. Sometimes, the investment can result in losses as well. You can use this investment to cut your taxes by selling it. So, only some of the investments that are going into losses are bad.

In short, you can lower the taxes you must pay from the other investments by selling this one. In this way, you will be able to make the best out of the dire conditions in investing.

However, there are some rules that you must adhere to to get all the benefits from this situation. In this guide, we will concisely understand the tax-loss harvesting, so let's get started:

How Tax-Loss Harvesting Helps in Reducing Tax?

You can sell down investments by tax-loss harvesting or replace them with similar ones. Then, you can offset your profits from the other investments by this loss. The final result comes as the difference between the profits and losses of the investment. Hence, your taxes can be reduced through this tax-loss harvesting.

Some of the investors may sell this investment and buy a new one with the hope that it may generate future gains and profits.

Also, keep in mind that if you have sold the investment while owning it for less than one year, it comes under the classification of short-term profits. You are required to pay taxes on this profit as your regular income tax, which will be the same amount you spend on your income or salary tax.

On the other hand, if you hold an investment for more than a year, it will be classified as a long-term capital profit.

The tax on long-term capital gain is generally more favorable than the short-term ones. Because it is usually lower than the income tax rate, and it depends on your income and how much you will pay. If your income comes under the lowest income tax brackets, you must pay 0% of the tax.

If you are a middle-income earner, you must pay 15% of your amount into taxes. Lastly, for the high-income earners, 20% of their salary will be deducted from the tax.

One more vital point to note is that you must complete your transactions before the end of the tax year if you want to harvest your losses. For instance, if you want to make up for your losses of 2024, the transaction must be done by December 31, 2024.

Limitations of the Tax-Loss Harvesting

Tax-loss harvesting may benefit from cutting taxes, but there are also some limitations associated with it. Some of them are given below:

You can generally sell the investment that is going down to offset the gain taxes from the other investments that are going well. However, this rule does not apply to retirement accounts like 401(k) or IRA accounts.

Because you don't have to pay taxes in these accounts until you make a withdrawal in retirement, since there are no taxes paid on the losses and gains within the retirement accounts, the tax-loss harvesting rule doesn't apply to this.

While there are also some limitations, even on the taxable investment accounts, on using certain types of losses to offset the gains, if your loss is long-term, you can only apply it to long-term gain.

Similarly, if the loss is short-term, it can only be applied to the short-term profits to offset the taxes. You can offset the gain only within the same category.

A wash-sale rule is also an important point to keep in mind while conducting the tax-loss harvesting. As per this rule, if you have sold the security at a loss or bought the new one within 30 days before or after the sale, you would not be able to cut your income taxes.

This rule prevents investors from selling securities that want to reduce taxes while keeping the same investment position. Therefore, you must stay out of the same investment after selling the previous one for 30 days to avoid the wash-sale rule.

How to Maximize the Value of Tax-Loss Harvesting?

The top way to increase the value of your tax-loss harvesting is to add your losses to your year-round tax planning and investment strategy. For this purpose, you must actively manage the tax implications of your investment decisions. One of the strategies is to use the individual investment pieces.

That means you can break down your portfolio into small pieces of investments instead of using large ones. With this approach, you will have greater flexibility in managing your taxes. With this approach, you can tax-harvest the small pieces as the market preferences change.

Also, to get the most out of the tax-loss harvesting, understand the importance of the wash-sale rules. You have to select your investment carefully and not buy a new one identical to those you have recently sold. You can choose similar but different security to comply with the wash-sale rules.

You can also easily integrate your tax-loss harvesting into the investment portfolio rebalancing. The rebalancing of the portfolio enables the investors to keep in line with the investment's long-term goals and the associated risks.

This tax-loss harvesting will prevent your portfolio from concentrating excessively on certain assets. You also have the opportunity to assess your investments within the investment portfolio.

Conclusion

Tax-loss harvesting is a great way to reduce your taxes on profitable investments from the losses of non-profitable investments. Even if you don't have the current gains, this method would help offset future gains and profits. Lastly, you can use up to 3000 dollars to offset future income taxes even if your losses exceed the gains.