Tax-loss harvesting can be an important part of an investment strategy, so it’s critical to understand what it is and how it works. Tax-loss harvesting is the selling of securities at a loss in order to help investors minimize any taxes they may owe by offsetting any realized capital gains — i.e., securities you’ve already sold at a gain. If you have a net realized loss at the end of the year, you may also be able to offset some ordinary income on your tax return.

Here are some examples of how to put tax-loss harvesting to work for you:

Paper loss

If you have a paper loss on a particular investment, a great strategy may be to sell it and immediately buy something similar but not identical. For instance, you might sell a S&P 500 index fund at a loss and then buy a Russell 1000 Large Cap Index Fund. This way you don’t miss out on potential market moves, but you get to use (or “harvest”) the loss for tax purposes. It can be very powerful if done correctly over time.

Bad markets

In March 2020, during the height of the market drop, you could have utilized this strategy and not missed the upside that followed. It can be used whether you hold individual equities or mutual funds.

Reduce income taxes

If you’re married and filing jointly and have realized a net loss of up to $3,000 (or $1,500 if married filing separately) on the year, you can use the strategy to offset ordinary income. If you’re in the 24% tax bracket, it could mean up to $720 in your pocket in tax savings.

Shield future gains

If you have an investment that has significantly underperformed (greater than a $3,000 loss), you can still benefit in the future. The losses in excess of $3,000 that you weren’t able to deduct from ordinary income the first year can be carried forward. That means if you had a net loss of $20,000 at the end of the year, you could use $3,000 to deduct from ordinary income, and you could use the other $17,000 in future years to offset gains or deduct from ordinary income again. In other words, you don’t lose the losses but can benefit from them in future years.

There are, however, a couple of cautions to consider:

• Wash sale: A common mistake is what is known as a “wash sale.” This occurs when an investor deducts a capital loss on the sale of a security and quickly buys back the same security. You are required by law to wait at least 30 days before buying back the stock to be able to deduct the loss for tax purposes.

• Administrative costs (or, “don’t get carried away”): Before you try to complete a transaction every time the market dips, remember that there are administrative costs that come with tax preparation, and the loss you’re harvesting should be greater than what you will pay in fees.

Keep in mind that ultimately, we believe investors should maintain a consistent strategy that aligns with their personal goals and objectives.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.