Tax Loss Harvesting: A Smart Strategy to Reduce Tax Bill

What Is Tax Loss Harvesting?

Tax loss harvesting is a strategy used by investors to reduce their tax burden by selling securities at a loss. These losses are then used to offset capital gains from other investments. If losses exceed gains, investors can deduct up to $3,000 from their ordinary income each year ($1,500 if married filing separately), with the excess carried forward to future tax years.

Tax Loss Harvesting: A Smart Strategy to Reduce Tax Bill

How Does Tax Loss Harvesting Work?

The process is simple in concept: sell an underperforming investment at a loss, use that loss to offset taxable gains, and reinvest the proceeds in a similar—but not “substantially identical”—security to maintain your investment exposure. This can reduce your overall tax liability without significantly altering your portfolio.

Let’s break it down:

Sell the losing investment.Use the realized loss to offset gains from other investments.Deduct up to $3,000 of excess loss from your regular income.Carry over any remaining losses to future years.

When Should You Use Tax Loss Harvesting?

While it’s most commonly applied at the end of the tax year (before December 31), tax loss harvesting can be used year-round—especially during periods of market volatility. It’s best used when:

You’ve realized significant short term capital gains.You want to rebalance your portfolio.You expect to be in a high tax bracket.

Short-Term vs. Long-Term Capital Gains

Understanding the types of gains and losses is crucial:

Short-term capital gains occur when an asset is sold after holding it for one year or less. These are taxed at your regular income tax rate.Long-term capital gains are taxed more favorably—at 0%, 15%, or 20%—depending on your income level.

Losses must first be matched with gains of the same type. Short-term losses offset short-term gains first, and long-term losses offset long-term gains.

The Wash Sale Rule: What to Avoid

The IRS wash sale rule disallows the deduction of a capital loss if you buy a “substantially identical” security within 30 days before or after the sale that generated the loss. This rule exists to prevent investors from selling an asset to claim a tax benefit and immediately repurchasing it.

To avoid triggering this rule:

Wait at least 31 days before buying the same security again.Replace the sold asset with a similar, but not identical, investment.Avoid automatic dividend reinvestments in the same stock or mutual fund.

Example of Tax Loss Harvesting in Action

Let’s say you sold Investment A for a $25,000 profit and Investment B for a $30,000 loss:

Your net capital loss is $5,000.You can offset the $25,000 gain completely.Use $3,000 to reduce your ordinary income.Carry over the remaining $2,000 loss to next year.

This can significantly lower your tax bill for the current tax year and provide a tax shield for future years.

Which Accounts Qualify?

Tax loss harvesting only applies to taxable accounts. You cannot use this strategy in tax-advantaged accounts like:

401(k)sIRAsRoth IRAs529 plans

That’s because these accounts are already protected from capital gains taxes.

Ideal Candidates for Tax Loss Harvesting

Tax loss harvesting works best for:

Investors with high taxable income.Those managing large taxable investment accounts.Individuals who actively trade stocks or ETFs.

If you’re in a low tax bracket or have minimal gains, the benefits may not justify the effort.

How to Reinvest After Selling

After selling an investment at a loss, reinvest the proceeds wisely. Consider:

Diversifying your portfolio.Buying ETFs or mutual funds with similar but not identical exposures.Balancing your asset allocation.

This keeps you invested in the market while remaining compliant with IRS rules.

Automating the Process

Many robo-advisors and investment platforms now offer automated tax loss harvesting. These services monitor your portfolio for opportunities and execute trades to minimize taxes without disrupting your investment strategy.

Popular robo-advisors with tax loss harvesting features:

BettermentWealthfrontVanguard (advisory services)Schwab Intelligent Portfolios

The Role of Cost Basis

Cost basis is the original value of an asset for tax purposes. When harvesting losses, it’s beneficial to identify and sell shares with the highest cost basis to maximize your realized losses.

There are multiple cost basis methods:

FIFO (First-In, First-Out)LIFO (Last-In, First-Out)Specific Identification (recommended for tax loss harvesting)

Specific identification allows you to choose which lots of shares to sell, optimizing your tax outcome.

Benefits of Tax Loss Harvesting

Lower taxes: Offset capital gains and reduce ordinary income.Portfolio rebalancing: Sell underperformers and reinvest in stronger assets.Tax deferral: Postpone paying taxes until later years when you might be in a lower bracket.Compounding advantage: Reinvest tax savings to grow your portfolio faster.

Risks and Considerations

Tax loss harvesting is not a foolproof strategy. Consider the following:

Potential for wash sale violations.Reinvestment risks: Replacement assets might underperform.Long-term consequences: Lowering cost basis today may result in higher taxes later.Administrative burden: Requires tracking purchases, sales, and holding periods.

Work with a tax advisor or financial planner to ensure you’re executing it correctly.

Tax Loss Carryforwards

If your total capital losses exceed your gains and the $3,000 ordinary income limit, the excess can be carried forward indefinitely. These carryforwards can be applied in future years to offset gains or reduce taxable income.

Real Estate and Other Capital Assets

Tax loss harvesting isn’t limited to stocks and mutual funds. It also applies to other capital assets like:

Real estate investmentsCryptocurrency (currently exempt from the wash sale rule)Collectibles and business assets

Each asset class comes with its own rules and tax implications. Consult a tax professional before applying the strategy to non-traditional investments.

Tax Loss Harvesting for Mutual Funds

Mutual fund investors can also benefit:

Use losses from one fund to offset gains from another.Watch for capital gain distributions near year-end.Be mindful of reinvested dividends that may trigger the wash sale rule.

ETFs are often a more flexible option due to their trading liquidity and variety of options that aren’t “substantially identical.”

Year-End Planning Tips

To maximize your tax savings:

Review your portfolio in Q4.Identify underperformers.Rebalance with tax efficiency in mind.Finalize transactions before December 31.

Note: Settlement takes time. Don’t wait until the last trading day to execute your plan.

Is Tax Loss Harvesting Worth It?

Yes, for many investors—especially those in higher tax brackets or with large gains—tax loss harvesting is an effective way to save money. However, if your portfolio is small or your income is modest, the impact might be limited.

Ultimately, the value of this strategy depends on your tax situation, income level, and investment goals.

Final Thoughts

Tax loss harvesting is a powerful, yet often underused, tool in a savvy investor’s toolkit. By strategically realizing losses, you can reduce your tax bill, reinvest more capital, and build long-term wealth. Just be sure to follow IRS rules, stay organized, and get professional advice if needed.

Looking for guidance on how to align your financial plan with your ideal retirement location? Connect with a trusted advisor today and take the first step toward building a secure, personalized retirement strategy.