Tax-Loss Harvesting Explained: Turning Investment Losses Into Tax Savings

Market drops are never fun, but they can create a valuable tax-planning opportunity for investments held in taxable accounts. That’s the idea behind tax-loss harvesting, a strategy that turns investment losses into tax savings while keeping your money invested. Used thoughtfully, it can reduce your tax bill and improve your after-tax returns over time.

How tax-loss harvesting works

When an investment in a taxable account, such as a regular brokerage account, is worth less than you paid for it, you have an unrealized loss. By selling that investment, you realize a capital loss, which can be used to reduce your taxes.

Capital losses can offset capital gains from other investments. For example, if you sold one investment for a $10,000 gain and another for a $10,000 loss, the loss would offset the gain, and you’d owe no capital gains tax on that $10,000.

If your losses exceed your gains, up to $3,000 a year, or $1,500 if married filing separately, can generally be used to offset ordinary income, such as wages. Any remaining losses can be carried forward to future years indefinitely, offsetting future gains or income.

Losses are applied first against gains of the same type, short-term losses against short-term gains and long-term losses against long-term gains, before offsetting the other type. Since short-term gains are taxed at higher ordinary income rates, offsetting short-term gains can be especially valuable.

Staying invested

Selling an investment to harvest a loss doesn’t mean you have to leave the market. Many investors reinvest the proceeds in a similar, but not substantially identical, investment so they stay invested and maintain their desired asset allocation.

For example, an investor might sell one broad stock market index fund and buy another that tracks a different but similar index, maintaining similar market exposure. Or they might sell an individual stock and buy a fund covering the same industry.

Staying invested matters because markets can rebound quickly after declines. Selling and sitting on the sidelines could mean missing a recovery.

The wash-sale rule

The wash-sale rule is the most important rule to understand. The IRS disallows a loss if you buy a substantially identical security within 30 days before or after the sale, a 61-day window in total.

This rule applies not only to purchases in the same account but also to purchases in your IRA, other brokerage accounts and your spouse’s accounts. Automatic dividend reinvestments can also trigger a wash sale if they occur within the window.

If a wash sale occurs, the disallowed loss isn’t lost permanently. It’s generally added to the cost basis of the new shares, deferring the loss until you sell those shares. However, if the replacement purchase occurs in an IRA, the loss may be permanently disallowed.

What counts as substantially identical isn’t precisely defined by the IRS. Shares of the same stock or two funds tracking the same index from different providers may raise questions, so many investors choose replacement investments that track different indexes to be cautious.

Things to keep in mind

Tax-loss harvesting lowers your cost basis in the replacement investment, which can mean higher taxable gains later when you sell. In this sense, harvesting often defers taxes rather than eliminating them. However, deferral can still be valuable, since money saved on taxes today can be invested and grow. And if you hold investments until death, heirs may receive a step-up in cost basis, potentially eliminating the deferred gain. Donating appreciated shares to charity can also avoid the gain.

Tax-loss harvesting is most valuable for high earners in higher tax brackets and investors with large taxable accounts or significant capital gains to offset. It may provide less benefit for investors in lower tax brackets, particularly those who qualify for the 0% long-term capital gains rate.

It doesn’t apply to tax-advantaged accounts like IRAs and 401(k)s, since gains and losses within those accounts don’t affect your taxes.

Transaction costs and bid-ask spreads, while often small, can reduce the benefits of frequent harvesting.

Be careful that harvesting doesn’t cause you to stray from your investment strategy. Tax considerations shouldn’t override sound investment decisions.

When to harvest

Opportunities for tax-loss harvesting often arise during market downturns or when specific investments decline. Many investors review their portfolios for harvesting opportunities periodically, rather than only at year-end. Losses must be realized by December 31 to count for that tax year.

Automated harvesting

Some robo-advisers and wealth managers offer automated tax-loss harvesting, monitoring portfolios and harvesting losses when opportunities arise while avoiding wash sales within the accounts they manage. Direct indexing, which involves owning individual stocks that make up an index rather than a fund, can provide more opportunities for harvesting losses on individual securities.

Get advice

A tax professional can help you harvest losses effectively, track your cost basis and carryforwards, and avoid running afoul of the wash-sale rule, especially if you have multiple accounts or complex investments.