How Does Tax-Loss Harvesting Work?

Nobody likes to see their investments lose value, but there may be a silver lining. While tax-loss harvesting can't erase investment losses, it may help you minimize your tax burden.

Tax-loss harvesting allows you to use capital losses to offset any capital gains. If you're an investor with a sizable portfolio, understanding how tax-loss harvesting works can help you make the most of your money—even when the market isn't cooperating.

What is tax-loss harvesting?

Tax-loss harvesting involves selling investments that have decreased in value to offset the taxes on capital gains incurred from the sale of other investments.

This strategy comes into play when you sell a tradable security in a taxable account at a loss. Recognized capital losses aren't available for trades within tax-advantaged accounts like 401(k)s or IRAs. Thirty days before or after the sale, you may purchase similar—but not identical—investments to maintain your current market exposure. In this way, you can potentially lower your tax bill while maintaining your overall investment strategy.

How tax-loss harvesting works

The first step in tax-loss harvesting is to identify securities in your portfolio that have decreased in value since you purchased them. These are your potential capital losses. If you choose to sell these investments, your unrealized losses will become actual capital losses. These realized losses can then be used to offset realized capital gains from other investments.

Then, to maintain your overall portfolio exposure, look to purchase new investments that could serve as suitable replacements for what you've sold. These replacements can have similar characteristics to the sold assets but must be different enough to avoid triggering the wash-sale rule.

Understanding the wash-sale rule

When it comes to tax-loss harvesting, the IRS doesn't want investors to game the system. That's why the agency has implemented the wash-sale rule, which prohibits investors from purchasing a substantially identical security within 30 days before or after they've sold an investment at a loss. If you violate this rule, the IRS will disallow the loss.

What is a substantially identical security?

The IRS doesn't give a precise definition, but you can usually invest in assets that are quite similar. For example, selling one S&P 500 index fund and buying a different S&P 500 fund from another provider may be considered acceptable. Another example would be selling shares of a technology sector exchange-traded fund, or ETF, and replacing it with a handful of individual tech stocks.

In both scenarios, you remain diversified—with exposure to potential growth in the sector—but you've also locked in a tax loss that can offset gains elsewhere in your portfolio.

Carrying forward capital losses

What if your capital losses exceed your capital gains? On the bright side, you're not losing out on potential tax benefits. You may apply up to $3,000 of these excess capital losses against ordinary income, such as wages, interest and dividends.

The IRS will also allow you to carry losses forward to future tax years without an expiration date. This means you can use excess losses to offset gains or income in coming years.

Common questions

Tax-loss harvesting is a popular strategy for minimizing taxable investment gains, but it often raises questions about its timing, uses, benefits and potential drawbacks.

Does tax-loss harvesting eliminate taxes?

It's important to note that tax-loss harvesting doesn't eliminate taxes—it simply defers them. Delaying taxes in this way may still be advantageous, especially if you reinvest the savings, which can enable your portfolio to grow beyond what you'll pay later.

Can short-term losses offset long-term gains?

Another consideration is how long you've held the investment. Short-term losses must first offset short-term capital gains, and long-term losses must first offset long-term gains. Only then can they offset capital gains of the other type.

Because short-term gains are taxed at a higher rate, most investors opt to use tax-loss harvesting to offset short-term gains.

When should a loss be recognized?

Tax-loss harvesting can be done at any time. However, many investors use it as an end-of-year tax strategy. Taking this approach provides a more accurate view of the total amount of realized short- and long-term capital gains you've collected that year.

But strategic investors also keep an eye out for opportunities throughout the year—especially during market downturns—because those losses may not be available to harvest later. Just remember that the deadline for tax-loss harvesting is December 31.

Factors to consider

While tax-loss harvesting can be a smart strategy, it's not always appropriate for every investor or situation. These four factors may determine whether tax-loss harvesting makes sense for you.

Tax bracket

The higher your tax bracket, the more beneficial tax-loss harvesting can be because the potential tax savings are directly proportional to your marginal tax rate. For instance, if you're in the 37% tax bracket, offsetting $8,000 in short-term capital gains could save you nearly $3,000 in taxes. However, if you're in the 22% bracket, the same $8,000 offset would only save you $1,760.

Portfolio size

Generally, you need a substantial amount invested to make tax-loss harvesting worthwhile. With a larger portfolio, there's a higher likelihood of having individual positions large enough to generate meaningful losses for harvesting. A 5% loss on a $10,000 portfolio is only $500. However, a 5% loss on a $100,000 portfolio is $5,000.

Long-term goals

The primary benefit of tax-loss harvesting is the immediate tax savings in the current year. For long-term investors, the tax you're deferring will ultimately come due when you sell. Because those investments have more time to appreciate, you may eventually owe more in capital gains tax in the future.

Mindset

A final consideration is whether you can prevent your emotions from getting in the way. Investors often struggle with the behavioral bias of loss aversion, where the pain of losing is psychologically more powerful than the pleasure of gaining. This can make it emotionally challenging to sell investments at a loss, even if it's beneficial from a tax perspective. It's best to approach tax-loss harvesting with a clear, objective mindset.

The bottom line

This strategy can be a smart way to make your portfolio more tax efficient. However, it requires careful tracking and timing. While minimizing taxes is important, it shouldn't be the driving factor in your investment decisions. Always keep your focus on your overall financial health and long-term investment objectives. A tax professional and financial advisor can help you assess whether tax-loss harvesting may benefit you.