What is Tax-Loss Harvesting
Tax-loss harvesting means that you sell investments at a loss in order to offset gains. This way you “harvest” the losses to offset gains and reduce your tax obligation.
This makes sense if:
The investor intends to sell the stock anyway or does not believe that the losses will turn to gains.
Assume the investor has a realized, taxable gain of $100 and owes $20 on that gain.
-> The tax bill is $20
The investor has another stock with an unrealized loss of $100 that they intend to sell. If they sell this before the end of the year the $100 loss counts against the gain, reducing the gain to 0.
-> The tax bill is 0
However, if the investor believes the stock is undervalued and will soon recover the loss and yield a gain this strategy may not make sense. You would have to weigh the gain of tax saved versus the potential gain of holding on to the stock.
Tax-loss harvesting as an ongoing strategy
If an investor sells a stock then immediately re-buys the stock this is considered a wash sale. There is no realized loss.
However, investors can sell a stock, realize the loss, then buy a similar stock that they expect to perform the same way.
Perhaps they expect Apple and Microsoft to perform about the same. They have an unrealized loss in Apple. So they sell out of Apple and buy Microsoft, realizing the loss while retaining the opportunity for upside.
This strategy is most effective when mimicking an index.
Often investors will buy a basket of stocks that replicate the performance of the S&P 500 then they sell and buy at the end of the year in such a way that they realize losses but continue to replicate the S&P 500.