Tax-loss harvesting is one of the various strategies for investors to offset their annual tax liability. Although it has become increasingly popular in many automated portfolio management platforms, what does tax-loss harvesting mean and who should consider it?

Before relying on an algorithm to do the work, let’s take a look at how tax-loss harvesting can impact both your investment strategy and potential tax liability.

Tax-loss harvesting involves selling a security that has lost value in your portfolio. By disposing of the asset at a loss, also known as realizing, or harvesting, you may be able to offset capital gains taxes. Even without capital gains to offset, selling depreciated assets may allow you to reduce current ordinary income by $3,000 or carry the loss forward to future years.

After the financial securities are sold, the proceeds are often used to purchase a similar investment. In practice, tax-loss harvesting is done as a part of a comprehensive investment management strategy. You will need to keep your current (or desired) asset allocation in mind, and ideally approach tax-loss harvesting at the same time as portfolio rebalancing. Although tax-loss harvesting may seem like an attractive tactic to maximize after-tax returns, there are certain limitations and points to consider.

Know the IRS limitations. The Internal Revenue Service has specific guidelines for realizing losses. First, once all capital gains and losses have been netted, you can only deduct up to $3,000 of losses (or $1,500 for married filing separately) from your ordinary income in any one year. Any losses over this limit can be carried forward to future years.

Due to the wash-sale rule, if an identical, or substantially identical asset is purchased within a 30-day period of the realization of the loss, the investor will not get any tax reductions;however, an asset of high correlation, while not substantially identical, is allowed . This is important for investors to know when considering selling an asset that fits into long-term investment goals that may not be easily substitutable.

Other considerations. When deciding whether to rebalance, it is important to consider the asset’s role in your diversified portfolio, similar alternatives and the costs of the transactions. Depending on your tax bracket, the benefits of tax-loss harvesting may not be worthwhile. Investors receiving the biggest benefits from this strategy tend to be in the higher tax brackets and have sufficient short-term losses.

The procedure for netting capital gains first applies to gains and losses of the same holding period (e.g. long-term gains against long-term losses) before netting short and long-term gains and losses together. Short-term assets are held for less than a year and are taxed at your higher ordinary income rate. Since long-term assets are taxed more favorably, it may not make sense to harvest these losses.

Another point to consider is that consistent tax-loss harvesting can eventually raise your future tax rate. As assets are sold and new ones purchased, the investor’s basis will likely be lower in the new security. Here’s why this matters (at a high level): As an investor holds a security over time, certain taxable events occur, such as the distribution of a dividend. Although typically currently taxable, in many situations the dividend will increase your adjusted basis in the asset. This is important because when the security is ultimately sold, the taxable portion will be the difference between the current market value and your adjusted basis.

While it may not be fit for every investor, for many individuals there are clear benefits to this strategy. Especially after a market correction when many portfolios have declined in value and also require rebalancing to return to the intended asset allocation, tax-loss harvesting can be most useful. As mentioned, the mechanics of tax-loss harvesting can be rather complex. While innovations in automated programs have made it much easier, there are also distinct benefits of working with a personal financial advisor who understands your goals and risk tolerance, and can help you weigh the decision in consultation with your professional tax advisor.

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‘Tis the Season for Tax-Loss Harvesting originally appeared on usnews.com