When your investments decline in value, there's usually not much to celebrate. But there is one silver lining: tax-loss harvesting. This strategy lets you turn paper losses into real tax savings, essentially making lemonade from the market's lemons.
How Tax-Loss Harvesting Works
The concept is simple: sell investments that have declined below your purchase price, realize the loss for tax purposes, then reinvest the proceeds to maintain your market exposure. The loss you realize can offset gains elsewhere in your portfolio or even reduce your ordinary income.
The Tax Benefit:
โข Capital losses first offset capital gains dollar-for-dollar
โข Excess losses can offset up to $3,000 of ordinary income annually
โข Remaining losses carry forward indefinitely to future years
Example: You have $10,000 in capital gains from selling a winning stock. You also hold an investment that's down $8,000 from your purchase price. By harvesting that $8,000 loss, you reduce your taxable gains to just $2,000, potentially saving $1,800+ in taxes (at 24% bracket).
The Wash Sale Rule
There's one critical rule you must follow: the wash sale rule. The IRS disallows a loss if you buy a "substantially identical" security within 30 days before or after the sale.
What triggers a wash sale:
- Buying the same stock or fund within 30 days (before or after)
- Buying it in a different account (including IRA or spouse's account)
- Buying an option on the same security
What doesn't trigger a wash sale:
- Buying a similar but not identical security (e.g., different S&P 500 ETF)
- Buying stock in same sector but different company
- Waiting 31+ days to repurchase
๐ ๏ธ Recommended Tool
Wealthfront and other robo-advisors offer automated daily tax-loss harvesting, catching opportunities you might miss. For DIY investors, most brokerages now show unrealized gains/losses in your account dashboard.
Practical Tax-Loss Harvesting Strategies
Strategy 1: Year-End Harvesting
Review your portfolio in November/December. Look for positions with unrealized losses that can offset gains you've realized during the year. This is the most common approach.
Strategy 2: Ongoing Harvesting
Don't wait for year-end. Market dips throughout the year create harvesting opportunities. A 10% correction in March might recover by December. Harvest the loss while it exists.
Strategy 3: The "Swap and Replace"
Sell your losing position and immediately buy a similar (but not identical) investment to maintain market exposure. Examples:
- Sell Vanguard Total Stock Market ETF (VTI), buy iShares Core S&P Total U.S. Stock Market ETF (ITOT)
- Sell SPDR S&P 500 ETF (SPY), buy Vanguard S&P 500 ETF (VOO)
- Sell one tech stock, buy a different tech stock or tech sector ETF
When Tax-Loss Harvesting Makes Sense
Ideal candidates:
- High-income earners in the 32%+ tax brackets
- Investors with significant realized gains to offset
- Those with concentrated positions that have declined
- Taxable brokerage accounts (not IRAs. No tax benefit there)
Less valuable for:
- Those in the 0% capital gains bracket
- Investors planning to hold indefinitely (step-up basis at death)
- Small losses that aren't worth the effort
๐ Further Reading
The Bogleheads' Guide to Investing includes an excellent chapter on tax-efficient investing, including when and how to implement tax-loss harvesting within a broader investment strategy.
The Long-Term Consideration
Tax-loss harvesting isn't free money. It's tax deferral. When you harvest a loss, your new investment has a lower cost basis. When you eventually sell, you'll owe more in capital gains.
Why it's still valuable:
- Time value of money. A dollar saved today is worth more than a dollar paid later
- You might be in a lower bracket when you sell
- Step-up in basis at death eliminates deferred gains entirely
- The $3,000 ordinary income deduction is a real reduction, not deferral
Common Mistakes to Avoid
Triggering wash sales inadvertently. Watch for automatic dividend reinvestment or systematic purchases in the 30-day window.
Letting taxes drive investment decisions. Don't hold a bad investment just to harvest losses later. Don't avoid selling a winner just to defer taxes.
Forgetting about state taxes. Harvesting is even more valuable in high-tax states like California or New York.
Not keeping good records. Track your cost basis and wash sale adjustments carefully.
The Zen Take
Tax-loss harvesting is one of the few free lunches in investing, not because it creates wealth, but because it improves your after-tax returns without changing your market exposure or risk.
The best approach is systematic, not emotional. Don't harvest losses because you're frustrated with an investment. Don't avoid it because you're hoping for a rebound. Set a threshold (perhaps 10% loss), review quarterly, and execute mechanically.
And remember: this strategy only applies to taxable accounts. Your 401(k) and IRA don't care about tax-loss harvesting. Everything is taxed the same when you withdraw.