Losing money is never fun. But it can lower your tax bill.
How Tax-Loss Harvesting Works
When you sell an investment for less than you paid, you realize a capital loss. That loss can offset capital gains dollar for dollar. If your losses exceed your gains, you can deduct up to $3,000 against ordinary income per year. Any remaining losses carry forward indefinitely to future years.
The key insight: you don't have to abandon your investment thesis. You sell the losing position, immediately buy a similar (but not identical) investment, and stay invested — while banking a tax deduction.
Step-by-Step Example
- 1. You own $15,000 of a tech ETF — now worth $10,000. You're sitting on a $5,000 unrealized loss. The market dropped, but you still believe in the long-term thesis.
- 2. Sell the position and realize the $5,000 loss. You now have a $5,000 capital loss locked in, usable to offset $5,000 of capital gains from other investments.
- 3. Immediately buy a similar (not identical) ETF. You reinvest in a different tech ETF or a total market ETF, maintaining your market exposure while the 30-day wash-sale window passes.
- 4. Use the loss to offset gains or income. $5,000 loss offsets $5,000 of capital gains. If you have no gains, you can deduct $3,000 against ordinary income this year and carry the remaining $2,000 forward.
The Wash-Sale Rule — the #1 mistake to avoid. If you sell a security at a loss and buy the same or substantially identical security within 30 days before or after the sale, the IRS disallows the loss. The 30-day window goes both directions — you can't buy first, sell at a loss, and buy again.
| Action | Example |
|---|
| ❌ Triggers wash-sale | Sell SPY at a loss → buy SPY the next day |
| ❌ Likely triggers wash-sale | Sell SPY → buy VOO (both track S&P 500) |
| ✅ Usually safe | Sell SPY → buy VTI (total market ETF, broader exposure) |
| ✅ Safe | Sell SPY → wait 31+ days → buy SPY again |
| ✅ Safe | Sell an individual stock → buy an ETF in the same sector |
Note: "Substantially identical" isn't perfectly defined by the IRS. When in doubt, choose a fund with a clearly different index or broader scope.
How Losses Are Applied
The IRS has a specific netting order for capital gains and losses:
- 1. Short-term losses offset short-term gains first.
- 2. Long-term losses offset long-term gains first.
- 3. Net short-term loss offsets net long-term gain (or vice versa) — cross-netting after same-type is exhausted.
- 4. Remaining net loss offsets up to $3,000 of ordinary income — reduces W-2/1099 income directly.
- 5. Any remaining loss carries forward to next year, indefinitely, with no expiration.
What a $10,000 Harvested Loss Is Worth
Assuming a $10,000 harvested loss applied to gains:
| Use | Value |
|---|
| Offsetting short-term gains (22% bracket) | $2,200 saved |
| Offsetting long-term gains (15% rate) | $1,500 saved |
| Offsetting ordinary income — only $3,000 allowed (22% bracket) | $660 saved |
Best use: offset short-term gains first — highest tax rate saved.
When Does Tax-Loss Harvesting Make Sense?
- ✅ You have realized or expected capital gains this year — if you've already sold winners or plan to, harvesting losses directly offsets those gains, potentially at a 15–20% savings rate.
- ✅ You're in a taxable brokerage account — tax-loss harvesting only applies to taxable accounts. Gains and losses inside IRAs and 401(k)s have no tax impact since they're already tax-advantaged.
- ✅ You have large unrealized losses during market downturns — market corrections are prime harvesting opportunities. A 20% drop creates significant losses to harvest while you stay invested via a replacement fund.
- ❌ You're in a very low income year (0% LTCG bracket) — if you're already paying 0% on long-term gains, harvesting losses has limited value. You may actually want to harvest gains at 0% instead.
Automate it — robo-advisors do this continuously. Platforms like Betterment, Wealthfront, and Fidelity's managed accounts scan your portfolio daily for harvesting opportunities. For significant taxable portfolios (typically $100K+), automated harvesting can generate meaningful annual savings. If you manage your own portfolio, a year-end review in November–December is a good time to scan for positions with unrealized losses before the tax year closes.
Key Terms
- Tax-Loss Harvesting: the practice of selling an investment at a loss to generate a capital loss that offsets capital gains — or up to $3,000 of ordinary income per year — reducing your current tax bill.
- Wash-Sale Rule: an IRS rule that disallows a capital loss if you buy the same or a "substantially identical" security within 30 days before or after the sale. The loss isn't gone forever — it's added to the cost basis of the new shares.
- Capital Loss Carryforward: if your capital losses exceed gains plus the $3,000 ordinary income limit, the unused losses carry forward indefinitely to future tax years.
- Substantially Identical: two securities are substantially identical if they represent the same economic exposure. Selling SPY and buying VOO (both S&P 500 ETFs) may trigger the wash-sale rule; selling SPY and buying a total market ETF typically does not.
Key Takeaways
- Sell losers to realize capital losses — use them to offset gains or up to $3,000 of ordinary income.
- Stay invested by immediately buying a similar (not identical) replacement fund.
- Wash-sale rule: no buying back the same or substantially identical security within 30 days before or after the sale.
- Unused losses carry forward indefinitely — no expiration.
- Only applies to taxable accounts — IRAs/401(k)s are already tax-sheltered.
- Best time to harvest: market downturns, or when you have significant gains to offset.
