Tax-loss harvesting can help lower your tax bill: Here's what to know

The recent volatility in the stock market can certainly be unsettling for investors. You may, however, be able to benefit from using this market downturn to your advantage through a common investing strategy called "tax-loss harvesting."

What may sound like a complicated technique is actually quite simple. Tax-loss harvesting essentially means using your investment losses to offset the taxes you would pay on other investment gains, otherwise lowering how much you'll owe Uncle Sam come next year.

"Tax-loss harvesting is a practice used by investors each year to minimize their tax exposure, ultimately maximizing after-tax returns," Eric Bronnenkant, CFP, CPA and head of tax at Betterment, tells Select.

Below, Bronnenkant helps us to break down exactly how tax-harvesting works.

At the end of each year, investors are required to pay what's known as a capital gains tax on the net profits (i.e. "gains") that they made by selling investments over the last 12 months. As we well know, not all investments are winners and therefore some may have decreased in value from the time the investor purchased them, Bronnenkant explains.

For these investments that have gone down in value and are now worth less than the initial outlay, investors can sell them and "harvest" those losses to write off against their other gains or income for the year. This move effectively decreases the net amount that the investor will be taxed on.

"Usually, investors will then replace the sold asset with a similar one to maintain the portfolio's balance in allocation and expected returns," Bronnenkant adds.

Once net capital gains have been reduced to zero, or if you don't have investment gains, you can also potentially use your losses to offset up to $3,000 in ordinary income. This could be a substantial savings. Tony Molina, CPA and senior product specialist at Wealthfront, gives the example that if you have a marginal tax rate of 30%, and you’ve been able to offset $3,000 in income, you’d be saving nearly a grand, or $900.

If you're thinking of implementing tax-loss harvesting, Bronnenkant wants investors to beware of violating what is called the "wash-sale rule." This rule basically prohibits investments sold at a loss and then repurchased within 30 days to be claimed for tax purposes. This includes the same investment or "substantially identical" stock or security. Keep in mind that not all investments are subject to the wash-sale rule. For example, you can immediately buy back into bitcoin after you realize a loss.

Tax-loss harvesting can be challenging to take on as a do-it-yourself investor, Bronnenkant suggests. But with a robo-advisor, investing software will automatically do the tax-loss harvesting for you so you can be hands-off.

If you're seeking a robo-advisor platform that offers tax loss harvesting for your taxable brokerage account, consider platforms like Betterment, Wealthfront or Charles Schwab.

Based on a customer's selected allocation and risk tolerance, Betterment's algorithms will keep an eye on a portfolio's profit/loss and look for opportunities to harvest losses regularly, reducing tax exposure throughout the year while avoiding wash sales. Betterment also offers a "tax impact preview" tool that lets you see how much you might have to pay in taxes before withdrawing funds.

Wealthfront says its tax-loss harvesting can help offset the advisory fee, an already low 0.25% annually. And for those with larger amounts of capital, Schwab's tax-loss harvesting kicks in for clients who have invested assets of $50,000 or more. When an investment declines in value, Schwab's automatic tax-loss harvesting will help offset the taxes on investment gains.

While robo-advisors provide a simple way to get started investing, we suggest talking to your financial advisor about what they recommend as the best tax-harvest strategy for you.

If you've harvested investing losses, using tax software like TurboTax (ranked best overall by Select) or H&R Block can make it easier to correctly input and claim those losses on your taxes, which will hopefully reduce your overall tax bill.

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