Tax loss harvesting is an investment strategy to lower your tax liability. The process involves selling investments at a loss and deducting these losses against capital gains. If there are losses leftover, they are deducted from ordinary income. The losses offset your gains you made that year which results in a lower tax liability. These losses can also be carried forward for up to $3,000 per year.

Tax loss harvesting defers taxes to a later date while also providing a lower cost basis. When you sell the investment in the portfolio, you will need to allocate the amount to a similar asset class. For example, if you sell a bond fund, you will replace it with a similar bond fund to keep the portfolio allocation in line. The asset chosen has to be different than the asset sold, or else it creates a ‘wash sale’, which throws away the benefit of tax loss harvesting. A wash sale exists when you sell at a loss, and then buy the same or “substantially identical” security within a 30-day period. This can sometimes happen if you reinvest dividends, and after you sell them at a loss. The distribution/dividend is then reinvested after. When you buy the new fund, you realize a lower cost basis which will cause a higher tax later on when you sell the investment (assuming it gains in value). One of the key benefits of tax loss harvesting is leaving more money now to be compounded into the future.

There are both short-term losses and long-term losses. Short-term losses are less than a year, and long-term losses are greater than one year. These losses must match the short term (long-term) gains first, and then can be carried over to offset long-term (short-term) gains. So, you can’t use short term losses to offset long-term gains until you offset all short-term gains. If there are losses leftover, they are deducted from ordinary income up to $3,000. After this, the losses are carried over into the next year to offset gains.

When tax loss harvesting, you must look for appropriateness for the account, and if it is in line with the overall investment strategy. Tax loss harvesting works best for high income earners, non-retirees, and younger generations. Since tax loss harvesting delays your taxes, it leaves more money to be compounded in the present. The results of tax loss harvesting have shown to improve long-term portfolio performance, in turn keeping more of your dollars invested today.