Tax-loss harvesting sounds like something only rich people with accountants worry about. It’s simpler than the name suggests and it can save ordinary investors real money on taxes. The basic idea: sell investments that have lost value, use those losses to reduce your tax bill, then buy something similar to keep your portfolio on track.
How it works
Say you bought $5,000 worth of a total stock market fund and it dropped to $4,200. You have a $800 unrealized loss. If you sell, that loss becomes realized and you can use it on your taxes.
Capital losses offset capital gains dollar for dollar. If you also sold another investment for a $800 gain this year, the loss cancels the gain and you owe zero tax on it. If you don’t have gains to offset, you can deduct up to $3,000 in capital losses against your ordinary income each year. Any excess losses carry forward to future years indefinitely.
$3,000 deducted from your ordinary income saves you $660 to $1,110 in taxes depending on your tax bracket (22% to 37%). That’s real money for doing nothing more than selling one fund and buying a similar one.
The wash sale rule
You can’t sell an investment at a loss and immediately buy the same thing back. The IRS calls this a wash sale, and it disallows the loss if you buy “substantially identical” securities within 30 days before or after the sale.
If you sell the Vanguard Total Stock Market ETF (VTI) at a loss, you can’t buy VTI back within 30 days. But you can buy the Schwab Total Stock Market ETF (SWTSX) or the iShares Core S&P Total US Stock Market ETF (ITOT) immediately. These track nearly the same index and keep your portfolio essentially unchanged, but they’re different enough securities to avoid the wash sale rule.
After 31 days, you can switch back to your original fund if you prefer.
When to harvest losses
The best time is whenever you have an investment sitting at a significant loss, especially if you also have gains to offset. Year-end is the most common time because people review their portfolios and want to reduce their tax bill before December 31.
But you don’t have to wait until December. Market dips during the year create harvesting opportunities. A 10% market correction in March means many of your holdings are temporarily below what you paid. Selling and repurchasing a similar fund locks in the loss for tax purposes while keeping your investment strategy intact.
Some robo-advisors (Betterment and Wealthfront) do tax-loss harvesting automatically throughout the year. This is one of the genuinely useful features they offer.
Who benefits most
Tax-loss harvesting is most valuable if you have taxable brokerage accounts with significant holdings. It doesn’t apply to 401(k)s, IRAs, or other tax-advantaged accounts because gains and losses in those accounts don’t have tax consequences until you withdraw.
If most of your investments are in retirement accounts, tax-loss harvesting doesn’t help much. But if you have $50,000 or more in a taxable brokerage account, the annual tax savings can add up to hundreds or thousands of dollars over time.
Higher tax brackets benefit more because the deduction is worth more. A $3,000 loss deduction saves someone in the 37% bracket $1,110. The same deduction saves someone in the 12% bracket $360.
What it doesn’t do
Tax-loss harvesting reduces or defers taxes. It doesn’t eliminate your tax liability permanently. When you eventually sell the replacement investment (hopefully at a gain), your cost basis is lower because you bought in at the lower price. You’ll owe capital gains tax on the larger gain at that point.
The benefit is time value: paying less tax now and more later. Since a dollar today is worth more than a dollar in the future, the deferral has real value. And if you hold until death, your heirs get a stepped-up basis that eliminates the deferred gain entirely. That’s a significant benefit for long term investors.
A simple example
You own $20,000 of a total stock market fund in your taxable brokerage. The market drops 15% and your position is now worth $17,000. You sell, realizing a $3,000 loss. You immediately buy $17,000 of a similar but not identical fund.
On your taxes, you deduct $3,000 against ordinary income. At a 24% tax rate, that saves you $720. Your portfolio is still invested in the stock market at the same dollar amount. The only thing that changed is your tax bill went down.
When the market recovers and your new fund grows back to $20,000 and beyond, your cost basis is $17,000 instead of $20,000. Eventually you’ll pay tax on that extra $3,000 of gain. But you had the use of that $720 in tax savings in the meantime, and if your investment timeline stretches decades, the deferral is worth real money.
Keep it practical
Don’t let the tax tail wag the investment dog. You shouldn’t sell a good investment purely for a tax loss if it disrupts your portfolio strategy. The replacement investment should be very similar to what you sold so your overall allocation doesn’t change.
Don’t harvest losses on investments you plan to sell for a gain in the same year. The loss and gain cancel out, and you’ve just created extra transactions for no benefit.
Do harvest losses during market dips if you have taxable accounts. The losses are a silver lining. You’re not selling because the market went down. You’re selling, buying something equivalent, and getting a tax benefit from an event that was going to happen to your portfolio anyway.