Tax-Loss Harvesting, Explained

Tax-loss harvesting shows up in robo-advisor marketing and personal-finance articles sounding like something only rich people's accountants do. It's a tax move with two rules, and you can learn both in five minutes. One prerequisite: this piece assumes you know how capital gains work, which Taxes on Your Investments covers.

Investments drop sometimes. Tax-loss harvesting means selling one while it's down, on purpose, to make the loss official in the eyes of the IRS, then putting the money into a similar (but not identical) investment so you stay in the market. Your portfolio barely changes. What changes is your tax return, because a realized loss has uses.

Losses apply in a fixed order. First, they cancel out capital gains, dollar for dollar and without limit: $5,000 of harvested losses wipes out $5,000 of gains you took elsewhere during the year. If losses exceed gains, up to $3,000 of the leftover reduces your ordinary income, the same income your paycheck is taxed on ($1,500 if married filing separately). That cap has sat at $3,000 since 1978. Anything beyond it carries forward to future years indefinitely, offsetting gains and income until it's used up.

Run the numbers before getting excited, though. Suppose your $4,000 portfolio drops 10%: harvesting the full $400 loss against ordinary income in the 12% bracket saves about $48. Worth taking if the opportunity is sitting in front of you; not worth building a strategy around. The dollars grow with the account, which is why this technique gets more attention the wealthier the audience.

The IRS anticipated the obvious cheat: sell, claim the loss, buy right back. The wash-sale rule disallows your loss if you buy the same or a substantially identical investment within 30 days before or after the sale. The window runs in both directions, 61 days in total counting the sale date, and it reaches into your IRA and your spouse's accounts too, so you can't dodge it by repurchasing somewhere else.

"Substantially identical" is the judgment call. Selling one company's stock and buying a different company's is clearly fine. Selling an S&P 500 index fund and buying another provider's fund tracking the same index is asking for trouble. The standard play is to swap into something similar but genuinely different, say a total-market fund in place of an S&P 500 fund, so you stay invested without voiding the loss.

Inside a 401(k), IRA, or HSA there are no capital gains taxes, which means losses there have no tax value to harvest. Everything in this article applies solely to a regular taxable brokerage account. If all your investing happens in retirement accounts, tax-loss harvesting is a strategy you can cheerfully ignore.

Harvesting rewards vigilance. Dips can be brief, and a human who checks quarterly misses most of them; software watching daily doesn't. That's why robo-advisors offer automated harvesting and market it prominently. It's a genuine feature, but know what it is: mostly a deferral, not an erasure. Selling low and rebuying lowers your cost basis, which sets up a larger taxable gain later. The bet, usually a reasonable one, is that a tax break today is worth more than a bigger gain taxed at low long-term rates decades from now.