Suppose that the stock market experiences a correction and some of your recent purchases are in the red. While you’re confident that they’ll move higher over the long run, you might wonder if you’re allowed to sell and realize the losses at the end of the year, since these losses could help offset some of your income taxes. This strategy is known as tax-loss harvesting and it’s a common technique used by wealthy investors to reduce their tax exposure.

In this article, we will take a closer look at the mechanics of tax loss harvesting, whether the strategy makes sense for your portfolio, and some tips to keep in mind if you use the strategy.

Tax Loss Harvesting 101

Tax loss harvesting is the process of selling a security that has experienced a loss, realizing the loss on the position for tax purposes, and replacing the security with the same or similar one to maintain an optimal asset allocation and expected returns. According to Betterment, a person that invests $50,000 at a 70 percent stock allocation with bimonthly deposits of $750 would have realized 0.77 percent higher annual returns between 2000 and 2013 from the strategy.

Let’s look at an example:

Suppose that you invest $10,000 into an S&P 500 index mutual fund in a taxable account that experiences a 10 percent correction. The holdings are worth $9,000 following the correction and you sell the fund for $9,000 in proceeds to realize a $1,000 loss. On the same day, you can purchase a Russell 5000 index mutual fund for $9,000 to replace that holding and write off the $1,000 in losses against your regular income taxes. You can also repurchase the same security after the wash-sale period expires (30 days) and still take the loss.

If you’re a savvy investor, you might realize that you still have to pay taxes on the gain in the future. It’s true that the process does not eliminate any taxes, but rather, it enables you to offset other taxable gains or taxes at an ordinary income rate (e.g. 33 percent). If you end up holding the security for over one year, future gains will be taxed at the advantageous long-term capital gains rate (e.g. 15 percent). Any delayed payment or tax savings can be reinvested and compounded until the investments are ultimately sold.

Tax loss harvesting works best for long-term investors with a long time horizon since you must hold a stock for over a year to benefit from the lower capital gains tax rate. The longer time horizon provides more time for the benefits of compounding interest. That said, retirement investors can still use the strategy if they’re not planning on selling the investment for more than a year, but they won’t benefit as much from compounding.

What’s the Catch?

The biggest catch is that tax loss harvesting can only be done in taxable accounts. If you have a tax-advantaged account, such as an IRA, 401(k), 403(bs), SEP-IRA, or 529, you cannot use tax loss harvesting strategies. The benefits of tax loss harvesting may seem appealing, but most investors are better off in tax-advantaged accounts. Since your investments grow completely tax-free until you withdrawal the funds, you can capture many years of compound growth.

If you have a qualifying account, you must also be aware of the Wash Sale Rule, which states that you cannot deduct losses from sold securities when you buy “substantially identical” securities within 30 days before or after the transaction. In other words, the IRS doesn’t want you to game the system by simply selling and immediately replacing the same stock any time that it moves lower just to realize the tax write-offs.

The good news is that it’s easy to work around the Wash Sale Rule. If you’re primarily invested in funds, you can simply swap an ETF that trades at a loss with another one that tracks a separate index but still has a high correlation. The IRS does not consider these ETFs to be “substantially identical” since they track different underlying indexes. Stock investors can do the same by selecting companies that are correlated but not identical.

The most common mistake that investors make with the Wash Sale Rule is forgetting to account for these transactions across various accounts. For example, you might own an S&P 500 index fund in one portfolio that you sell to realize a loss but purchase an S&P 500 index fund in a completely separate portfolio through a regularly scheduled contribution. The transaction would trigger the Wash Sale Rule and you would lose your tax savings.

Tips to Keep in Mind

Tax loss harvesting is a relatively straightforward strategy, but it can be complex to implement in practice. In addition to getting your tax lot and cost basis information, you must identify the appropriate funds to replace those losses without violating the Wash Sale Rule. You can then choose to harvest these tax losses monthly, quarterly, or yearly, although you should make sure that the benefits outweigh the transaction costs.

Each December, we guide our clients through the tax-loss harvesting analysis on their portfolio. If they have a security that has declined in price and fits some other criteria specific to the Snider Investment Method, we utilize the losses to offset option income and capital gains earned throughout the year.

The strategy can also be combined with charitable giving and gifting strategies to further reduce taxes. For example, you might realize a loss and take the tax savings in the current year and then, later in life, gift that position to your children. They receive a step-up in basis and the capital gains tax on the position is never paid. You can also gift the most appreciated positions to a charity instead of using cash and avoid the capital gains (as well as get another tax break).

The Bottom Line

Tax loss harvesting is a great way to reduce tax exposure in taxable accounts, but it involves some effort to avoid the Wash Sale Rule. When used with giving strategies, it’s a great way to increase returns over time and reduce exposure to deferred taxes down the road. Tax loss harvesting can also be used in conjunction with covered calls to offset option premiums generated during the year.