What Is Tax Loss Harvesting? Definition and More

This article is an excerpt from the Shortform book guide to "A Random Walk Down Wall Street" by Burton G. Malkiel. Shortform has the world's best summaries and analyses of books you should be reading.

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What is tax loss harvesting? How does this help investors to defer taxes?

Tax loss harvesting involves selling stocks at a loss and replacing those stocks with similar stocks, to pay less in taxes. Implementing this method means investors can defer their taxes while maintaining the risk/return rate of their stock portfolio.

So, what is tax loss harvesting? Keep reading to find out.

What Is Tax Loss Harvesting?

What is tax loss harvesting? Here’s a simple definition:

Tax Loss Harvesting (TLH) allows investors to defer taxes by trading stocks at a loss and replacing those stocks with correlated, but not identical, stocks. This move allows the investors to realize a loss—thereby lowering their tax bill—but also maintain the risk/return ratio of their portfolio.

For example, say that values of large automobile manufacturers have declined across the board. You decide to sell your shares of GM to realize a loss and reduce your tax burden, but at the same time you purchase Ford at a comparable price, thereby maintaining your position in automobile stocks. Although you’ll eventually have to pay taxes on those shares of Ford (if their value increases and they pay dividends), you’ll come out better than if you’d just pocketed the savings from the GM loss. This is because (a) your investment in Ford will compound over time and (b) the tax rate on your Ford capital gains is likely to save you more money than the GM capital loss did.

Many investment companies, for example Vanguard and Fidelity, now offer automated investment advisers that automatically engage in TLH. These companies also offer packages that include access to human advisers as well, but beware hefty expenses and fees.

What Is Tax Loss Harvesting? Definition and More

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Elizabeth Shaw

Elizabeth graduated from Newcastle University with a degree in English Literature. Growing up, she enjoyed reading fairy tales, Beatrix Potter stories, and The Wind in the Willows. As of today, her all-time favorite book is Wuthering Heights, with Jane Eyre as a close second. Elizabeth has branched out to non-fiction since graduating and particularly enjoys books relating to mindfulness, self-improvement, history, and philosophy.

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