Tax-Loss Harvesting Explained
Tax-loss harvesting is an investment strategy where you sell losing investments to offset capital gains taxes on your winners. It's a perfectly legal way to reduce your tax bill while keeping your portfolio strategy intact.
How Tax-Loss Harvesting Works
When you sell an investment for a profit, you owe capital gains tax. But if you also sell an investment at a loss, you can use that loss to offset the gain. The result: a lower tax bill.
Example
Say you have a $5,000 gain from selling Stock A and a $3,000 loss from selling Stock B. You only owe capital gains tax on the net $2,000 gain instead of the full $5,000.
The $3,000 Deduction
If your losses exceed your gains, you can deduct up to $3,000 of net losses against ordinary income each year. Any remaining losses carry forward to future tax years indefinitely.
The Wash Sale Rule
The IRS won't let you claim a loss if you buy a "substantially identical" investment within 30 days before or after the sale. This 61-day window (30 days before, sale day, 30 days after) is called the wash sale period.
To maintain your market exposure during this window:
- Buy a similar but not identical fund (e.g., sell one S&P 500 ETF, buy a Total Market ETF)
- Wait 31 days and repurchase the original investment
- Use the proceeds in a different asset class temporarily
Who Benefits Most From Tax-Loss Harvesting?
- High-income earners — higher tax brackets mean bigger savings from each dollar of loss
- Taxable brokerage account holders — tax-loss harvesting only applies in taxable accounts, not IRAs or 401(k)s
- Active investors — more transactions create more opportunities for harvesting
- Those with large capital gains — from selling property, business interests, or concentrated stock positions
When to Harvest Losses
- During market downturns — volatility creates harvesting opportunities
- Year-end — review your portfolio in November/December to identify losses before year-end
- Anytime — you don't have to wait until December. Losses can be harvested throughout the year
Tax-Loss Harvesting Best Practices
- Keep your asset allocation intact — reinvest proceeds in a similar (but not identical) investment
- Track your cost basis carefully — especially across multiple tax lots
- Consider long-term vs. short-term — short-term losses are more valuable because short-term gains are taxed at higher ordinary income rates
- Don't let the tax tail wag the investment dog — never sell a great investment just for the tax benefit
Automated Tax-Loss Harvesting
Robo-advisors like Wealthfront, Betterment, and Schwab Intelligent Portfolios offer automated tax-loss harvesting. They continuously monitor your portfolio and execute harvesting opportunities automatically.
The Bottom Line
Tax-loss harvesting is a smart strategy for investors with taxable accounts. It doesn't change your investment strategy — it simply optimizes the tax consequences. Even small amounts add up over time, especially when losses are carried forward across multiple years.
