Key Takeaways
- Tax-loss harvesting lets you use investment losses to offset gains and reduce your tax bill.
- The wash sale rule prevents repurchasing the same or substantially identical security within 30 days.
- Unused losses can offset up to $3,000 of ordinary income per year with unlimited carryforward to future years.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is a strategy that involves selling investments that have declined in value in order to realize a capital loss. That loss can then be used to offset capital gains from other investments, reducing the amount of tax you owe. If your losses exceed your gains, you can use up to $3,000 per year to offset ordinary income, with any remaining losses carried forward to future tax years indefinitely.
This strategy does not eliminate taxes forever. Instead, it defers them by lowering the cost basis of your replacement investment. However, the time value of that deferral is real: money that stays invested rather than going to the IRS has more time to compound and grow. Over a long investment horizon, the cumulative benefit of systematic tax-loss harvesting can add meaningfully to your after-tax wealth.
Tax-loss harvesting is most commonly employed in taxable brokerage accounts. It does not apply to tax-advantaged accounts like IRAs or 401(k)s, where gains and losses have no immediate tax impact.
How It Works: Step by Step
The process of tax-loss harvesting follows a clear sequence, and each step matters for both the tax benefit and the integrity of your investment strategy.
Step 1: Identify positions with unrealized losses. Review your taxable portfolio to find investments currently trading below your cost basis. These are your harvesting candidates. Losses can exist in individual stocks, bonds, mutual funds, or exchange-traded funds.
Step 2: Sell the position to realize the loss. When you sell, the loss becomes a realized capital loss that can be reported on your tax return. The loss is categorized as either short-term (held one year or less) or long-term (held more than one year), which determines how it offsets gains.
Step 3: Reinvest in a similar but not identical investment. To maintain your portfolio allocation and stay invested in the market, you purchase a replacement investment that provides similar exposure. For example, if you sold an S&P 500 index fund at a loss, you might buy a total stock market fund or an S&P 500 fund from a different provider. The key is that the replacement cannot be "substantially identical" to what you sold, or you will trigger the wash sale rule.
Step 4: Claim the loss on your tax return. Capital losses and gains are reported on Schedule D and Form 8949. Losses first offset gains of the same type (short-term losses offset short-term gains, long-term losses offset long-term gains), then cross-offset if there is excess.
Tax Savings in Action
The following scenarios illustrate how tax-loss harvesting produces real dollar savings in different situations. All examples assume a 15% long-term capital gains rate.
| Scenario | Capital Gains | Harvested Losses | Net Taxable Gain | Tax Rate | Tax Saved |
|---|---|---|---|---|---|
| 1: Partial Offset | $20,000 | $8,000 | $12,000 | 15% | $1,200 |
| 2: Full Offset | $15,000 | $15,000 | $0 | 15% | $2,250 |
| 3: Excess Losses | $5,000 | $12,000 | -$7,000* | 15% / Ordinary | $750 + income offset |
*In Scenario 3, the $12,000 in losses first offsets the $5,000 in gains. Of the remaining $7,000, $3,000 can be deducted against ordinary income in the current year (potentially saving $660 to $1,110 depending on your tax bracket), and the remaining $4,000 carries forward to future years.
The Wash Sale Rule
- The 30-Day Window: You cannot buy a "substantially identical" security within 30 days before or after the sale. This creates a 61-day window (30 days before, the sale date, and 30 days after) during which repurchasing the same investment disallows the loss.
- Substantially Identical Securities: The IRS does not provide a bright-line definition, but the same stock or same fund (even at a different broker) is clearly substantially identical. Different index funds tracking different indexes are generally considered acceptable replacements.
- Applies Across All Accounts: The wash sale rule applies across your taxable accounts, your IRA, your spouse's accounts, and entities you control. Selling a fund at a loss in your brokerage account and buying the same fund in your IRA within 30 days triggers the rule.
- Replacement Fund Strategies: Consider switching between fund families (e.g., Vanguard Total Stock Market to Schwab Total Stock Market), or switching between an index fund and a similar ETF from a different provider. After 31 days, you can switch back if desired.
Annual Loss Deduction Limits and Carryforward
When your realized capital losses exceed your realized capital gains for the year, you can deduct up to $3,000 of the net loss against your ordinary income ($1,500 if married filing separately). Any losses beyond that amount are not wasted. They carry forward to the next tax year, and the next, indefinitely, until they are fully used.
This carryforward feature makes tax-loss harvesting valuable even in years when you have no capital gains. Consider the following example of how excess losses roll forward over time:
| Year | Capital Gains | New Losses Harvested | Carryforward From Prior Year | Total Losses Available | Used Against Gains | Used Against Income ($3K max) | Carryforward to Next Year |
|---|---|---|---|---|---|---|---|
| 2025 | $2,000 | $15,000 | $0 | $15,000 | $2,000 | $3,000 | $10,000 |
| 2026 | $5,000 | $0 | $10,000 | $10,000 | $5,000 | $3,000 | $2,000 |
| 2027 | $0 | $4,000 | $2,000 | $6,000 | $0 | $3,000 | $3,000 |
As you can see, a single year of significant loss harvesting can provide tax benefits that stretch over multiple years. This is one reason why proactive, continuous harvesting is more effective than waiting until year-end.
Best Practices for Tax-Loss Harvesting
Monitor continuously, not just at year-end. Market volatility creates harvesting opportunities throughout the year. Waiting until December means you may miss dips that occurred in March or September. The best practitioners review portfolios regularly and harvest opportunistically whenever meaningful losses appear.
Pair harvesting with portfolio rebalancing. When you sell a position to harvest a loss, you have a natural opportunity to rebalance your portfolio. The replacement investment can be chosen to bring your allocation closer to your target, turning a tax strategy into a portfolio improvement as well.
Prioritize short-term losses when possible.
Short-term capital losses offset short-term capital gains first. Since short-term gains are taxed at ordinary income rates (up to 37%), a short-term loss saves more per dollar than a long-term loss that offsets gains taxed at the lower 15% or 20% long-term capital gains rate. When deciding which positions to harvest, short-term losses often deliver greater tax savings.
Keep detailed records. Track your cost basis, sale dates, replacement purchases, and 30-day windows carefully. Most brokerages track cost basis, but when you are managing the wash sale window across multiple accounts, personal records are essential.
Do not let the tax tail wag the investment dog. Tax-loss harvesting should complement your investment strategy, not drive it. Never hold a losing investment solely for the future harvesting opportunity, and never sell a strong position with embedded gains just because another position has a loss. The investment rationale should always come first, with tax efficiency as a valuable secondary benefit.
Coordinate with your overall tax plan. Tax-loss harvesting is most effective when integrated with your broader tax strategy, including Roth conversions, charitable giving, and income timing. Your financial advisor can help ensure that harvesting decisions align with and enhance your overall plan rather than creating unintended consequences elsewhere.
This article is for informational purposes only and does not constitute investment advice. All information should be discussed with a qualified financial advisor before implementation.
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