Tax-loss harvesting is an investment strategy that may help investors reduce their taxable capital gains by selling investments that have declined in value. It is commonly discussed by U.S. investors who hold stocks, exchange-traded funds (ETFs), mutual funds, or other investments in taxable brokerage accounts.
Although tax-loss harvesting can offer tax benefits, it does not eliminate investment losses or guarantee savings. Investors need to understand capital gains rules, wash-sale restrictions, and the difference between taxable brokerage accounts and tax-advantaged retirement accounts before using this strategy.
This guide explains how tax-loss harvesting works, when it may be useful, and what to consider before selling an investment at a loss.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is a strategy in which an investor sells an investment for less than its original cost to realize a capital loss. That realized loss may then be used to offset capital gains from other investments in a taxable brokerage account.
For example, suppose you purchased shares for $5,000 and later sold them for $3,800. You would generally realize a capital loss of $1,200, before considering transaction costs or other adjustments.
If you also sold another investment for a $2,000 capital gain, the $1,200 loss could generally offset part of that gain, leaving $800 in net capital gains before applying other tax rules.
The goal is not simply to sell losing investments. It is to manage taxable gains while keeping your broader investment strategy in mind.
How Does Tax-Loss Harvesting Work?
Tax-loss harvesting usually involves reviewing your portfolio, identifying investments with unrealized losses, and deciding whether selling them makes sense for your financial goals.
Here is how the process generally works.
1. Identify Investments With Losses
Review your taxable brokerage account to identify investments currently worth less than their cost basis. Your cost basis generally reflects what you paid for the investment, adjusted for certain transactions.
2. Sell the Investment
When you sell the investment for less than its adjusted cost basis, you generally realize a capital loss. The loss may be used to offset capital gains under applicable tax rules.
3. Offset Capital Gains
Capital losses generally offset capital gains. Short-term and long-term gains and losses are subject to specific netting rules, so the tax result depends on the types of transactions involved.
4. Decide How to Reinvest
After selling an investment, you may decide to purchase a different investment that fits your portfolio strategy. However, you must consider the wash-sale rule before buying the same or a substantially identical security.
Tax-loss harvesting should not replace a sound investment strategy. The investment you choose next should still fit your risk tolerance, time horizon, and financial objectives.
How Can Tax-Loss Harvesting Reduce Investment Taxes?
Tax-loss harvesting may help reduce taxes in several ways.
Offset Capital Gains
Realized capital losses can generally offset realized capital gains. This may reduce the taxable gains reported for the year.
For example, if you realize $4,000 in capital gains and $1,500 in eligible capital losses, your net capital gains may be $2,500 after applying the relevant rules.
Deduct Certain Excess Capital Losses
If your total capital losses exceed your capital gains, you may generally deduct up to $3,000 of the excess against ordinary income annually, or $1,500 if married filing separately. Unused capital losses may generally be carried forward to future tax years.
These limits and calculations are subject to IRS rules. You can review the official IRS guidance on capital gains and losses for more details.
Potentially Improve Tax Efficiency Over Time
Investors may use losses to manage taxable gains while maintaining a portfolio aligned with their long-term plans. However, tax savings depend on your actual gains, losses, income, and applicable tax rates.
A tax deduction does not make an investment loss disappear. Selling an investment at a loss still means your portfolio has lost value.
What Is the Wash-Sale Rule?
The wash-sale rule is one of the most important considerations in tax-loss harvesting.
Generally, if you sell stock or securities at a loss and acquire substantially identical stock or securities within 30 days before or after the sale, the loss deduction may be disallowed under the wash-sale rules.
This creates a 61-day window around the sale date that investors need to consider.
For example, imagine you sell shares of a company at a $1,000 loss and buy substantially identical shares again 10 days later. Your loss may be disallowed for the current deduction under the wash-sale rule.
The rules can also apply to purchases in an IRA or Roth IRA, as well as certain transactions involving a spouse. Keep accurate records of purchases, sales, and replacement investments.
Before selling an investment to harvest a loss, review the IRS rules on wash sales and investment transactions.
Which Investments Can Be Used for Tax-Loss Harvesting?
Tax-loss harvesting is generally relevant to investments held in taxable brokerage accounts, including:
- Individual stocks
- Exchange-traded funds (ETFs)
- Mutual funds
- Certain bonds and other securities
Tax treatment depends on the investment and transaction involved. Losses from investments held inside tax-advantaged retirement accounts generally do not provide the same current capital-loss deduction available for eligible losses in taxable accounts.
For investors who are building a long-term portfolio, understanding how compound interest grows savings can provide useful context about the importance of time, reinvestment, and consistent investing. Keep in mind that investment returns are not guaranteed, and tax-loss harvesting does not guarantee better performance.
Common Tax-Loss Harvesting Mistakes to Avoid
Selling Only for Tax Reasons
An investment should not be sold solely to create a tax deduction without considering its role in your portfolio. A tax benefit may be outweighed by transaction costs, market exposure changes, or other financial consequences.
Ignoring the Wash-Sale Rule
Buying substantially identical investments too close to a loss sale may prevent you from deducting the loss as expected. Check purchases across relevant accounts, including retirement accounts.
Forgetting Capital Loss Carryforwards
If you cannot use all your capital losses in the current year, eligible unused amounts may generally carry forward. Keep records and review prior tax returns when preparing future filings.
Overlooking Your Overall Financial Plan
Investment decisions should account for diversification, risk tolerance, and your time horizon. If you are organizing your financial strategy, AI personal finance tools may help with budgeting and tracking, although tax decisions still require careful review of applicable rules.
When Should You Consider Tax-Loss Harvesting?
Tax-loss harvesting may be worth reviewing when your taxable portfolio has investments trading below their adjusted cost basis, especially if you have realized capital gains during the same tax year.
However, the strategy is not appropriate for every investor. Your income, investment horizon, portfolio composition, transaction costs, and tax circumstances all matter.
Before acting, consider consulting a qualified tax professional or financial adviser who understands your situation. They can help you evaluate whether the potential tax benefit justifies the investment changes involved.
Final Thoughts
Tax-loss harvesting can be a useful tax-planning strategy for investors who hold investments in taxable brokerage accounts. By realizing eligible capital losses, investors may offset capital gains, deduct certain excess losses, and carry unused losses forward under applicable IRS rules.
The most important considerations are understanding capital-loss limits, avoiding wash-sale complications, and keeping investment decisions aligned with your long-term goals. Tax savings should support a thoughtful investment strategy rather than become the only reason for buying or selling an asset.
Always review current IRS guidance and your individual tax circumstances before making investment decisions.
