As the year draws to a close, tax-loss harvesting offers one of the few opportunities to generate value from investment disappointments. Done correctly, it can save you real money. Done incorrectly, it can disrupt your portfolio and create headaches. Here's how to do it right.
How Tax-Loss Harvesting Works
The basic concept is simple: sell investments that have declined in value to realize a capital loss, then use that loss to offset capital gains elsewhere in your portfolio. If your losses exceed your gains, you can deduct up to $3,000 against ordinary income annually, with any excess carrying forward to future years.
This isn't avoiding taxes. It's deferring them. When you eventually sell the replacement investment, your cost basis is lower, creating a larger future gain. But tax deferral has real value; a dollar of tax saved today can compound for decades before coming due.
The Step-by-Step Process
- Identify losers: Review your taxable accounts (not IRAs or 401(k)s) for positions showing losses. Focus on positions with meaningful losses. The effort isn't worth it for small amounts.
- Check holding periods: Short-term losses (held under a year) are most valuable because they offset short-term gains taxed at ordinary income rates. Long-term losses offset long-term gains taxed at lower capital gains rates.
- Calculate net gains: Estimate your expected capital gains for the year. Tax-loss harvesting is most valuable when you have gains to offset.
- Sell the losing position: Execute the sale before year-end (trades must settle by December 31).
- Buy a replacement: To stay invested in the market, immediately purchase a similar (but not identical) investment.
Critical rule: The wash sale rule prohibits claiming a loss if you buy a "substantially identical" security within 30 days before or after the sale. Buying the same ETF or fund within this window disqualifies your loss deduction.
Navigating the Wash Sale Rule
The wash sale rule exists to prevent gaming the system by selling and immediately rebuying the same thing. But you can maintain similar market exposure by switching to a comparable but not identical investment:
ETF swaps: Sell a Vanguard S&P 500 ETF (VOO) and buy an iShares S&P 500 ETF (IVV) or a total market ETF (VTI). These track similar but not identical indexes.
Index changes: Switch from an S&P 500 fund to a total market fund, or from a specific sector fund to a different slice of the market.
Factor tilts: Use the harvest as an opportunity to shift from a plain index to a value or quality-tilted version of similar exposure.
The key is maintaining your desired market exposure while technically owning a different security. After 31 days, you can switch back if desired.
When Not to Harvest
In retirement accounts: Tax-loss harvesting only works in taxable accounts. IRAs and 401(k)s don't generate taxable gains or deductible losses.
When you lack gains to offset: The $3,000 annual deduction against ordinary income is helpful but not transformative. Harvesting makes most sense when you have substantial gains to offset.
For small amounts: The complexity and potential for error isn't worth it for losses under a few hundred dollars. Focus on material opportunities.
When it compromises your strategy: Don't let the tax tail wag the investment dog. If harvesting would disrupt a carefully constructed portfolio, the tax benefit may not justify the cost.
Year-End Timing
December is prime time for tax-loss harvesting, but don't wait until the last minute. Trades take time to settle (T+1 for most securities), and brokerages get busy at year-end. Aim to complete harvesting by mid-December to avoid any settlement issues.
The Zen Take
Tax-loss harvesting is a valuable tool but not a complicated one. The fundamental insight. That realized losses have tax value, is worth acting on. But don't overthink it or chase tiny savings that aren't worth the effort.
Harvest meaningful losses, maintain your target exposure with replacement investments, and be mindful of the wash sale rule. That's really all there is to it. A simple process, executed annually, can add meaningfully to after-tax returns over time.