The Complete Guide to Tax-Loss Harvesting

Tax-loss harvesting sounds complicated - it isn’t.

At its core, the strategy involves selling investments at a loss to offset capital gains taxes. Investors have used this technique for decades, yet many overlook it entirely-leaving real money on the table.

A 2020 study by Wealthfront estimated that tax-loss harvesting adds roughly 1. 55% to annual after-tax returns for typical investors. That figure compounds significantly over a 20 or 30-year investment horizon. For someone with a $500,000 portfolio, we’re talking about thousands of dollars annually.

How Tax-Loss Harvesting Actually Works

The IRS allows investors to use investment losses to offset investment gains. When capital losses exceed gains in a given year, up to $3,000 of excess losses can offset ordinary income. Any remaining losses carry forward indefinitely.

Here’s a practical example:

Sarah bought 100 shares of a tech ETF at $150 per share ($15,000 total). The market drops. Her position now sits at $12,000-a $3,000 unrealized loss. Meanwhile, she sold another investment earlier in the year for a $4,000 gain.

Without tax-loss harvesting, Sarah owes capital gains tax on that $4,000. At a 15% long-term capital gains rate, that’s $600.

But if Sarah sells the tech ETF, she realizes the $3,000 loss. This offsets most of her gain. Now she only owes tax on $1,000 of net gains-$150 instead of $600.

She saved $450. And she can immediately reinvest in a similar (but not identical) investment to maintain her market exposure.

The Wash Sale Rule: Where Most Investors Trip Up

The IRS anticipated that investors might try gaming the system. Sell at a loss Monday, buy the same thing back Tuesday. Nice try.

The wash sale rule prevents exactly this. If an investor purchases a “substantially identical” security within 30 days before or after selling at a loss, the loss gets disallowed. It’s a 61-day window total-30 days on either side.

What qualifies as substantially identical? The IRS hasn’t provided exhaustive guidance, but the following generally applies:

• Same stock or bond: Always substantially identical
• Different share classes of the same fund: Substantially identical
• S&P 500 index funds from different providers: Debatable, but likely okay
• Total market fund vs. S&P 500 fund: Generally considered different enough

Most tax advisors recommend switching to a fund tracking a different index. Selling a Vanguard S&P 500 ETF (VOO) and buying a Schwab Total Market ETF (SWTSX) maintains broad market exposure while staying clear of wash sale concerns.

When Tax-Loss Harvesting Makes Sense (And When It Doesn’t)

Not every situation warrants harvesting losses. The math needs to work.

Best candidates for tax-loss harvesting:

• High-income earners in the 32%+ tax brackets
• Investors with significant realized gains in the current year
• Portfolios holding individual stocks with concentrated losses
• Those anticipating lower income in retirement (deferral benefits)

Skip it when:

• You’re in the 0% capital gains bracket (single filers under $44,625 in 2024)
• Transaction costs or trading spreads would eat into savings
• The loss amount is trivial (selling for a $50 loss isn’t worth the paperwork)
• You’re within 30 days of wanting that exact position back

A Vanguard analysis found that tax-loss harvesting provides the most benefit during market volatility. The 2008-2009 financial crisis and the March 2020 COVID crash created prime harvesting opportunities. Flat or consistently rising markets offer fewer chances.

useation Strategies: DIY vs. Automated

Two paths exist for executing tax-loss harvesting.

Manual approach:

Review your portfolio quarterly. Look for positions showing losses of $500 or more. Evaluate whether selling makes sense given your overall tax situation. Execute trades if the math works. Track everything meticulously for tax time.

Pros: Complete control, no additional fees.

Cons: Time-intensive, requires tax knowledge, easy to miss opportunities or trigger wash sales accidentally.

Robo-advisors and automated services:

Platforms like Betterment, Wealthfront, and Schwab Intelligent Portfolios automatically scan portfolios for harvesting opportunities. Some check daily. When they find losses worth harvesting, they execute the trade and swap into a similar fund.

Betterment claims their automated harvesting adds an average of 0. 77% annually - wealthfront’s figure mentioned earlier (1. 55%) comes from their more aggressive direct indexing approach, which holds individual stocks rather than ETFs.

Pros: Set-it-and-forget-it, catches more opportunities, tracks wash sales automatically.

Cons: Management fees (typically 0 - 25-0. 50% annually), less flexibility in investment choices.

For portfolios over $100,000, the automated approach often makes sense. The time savings alone justify the fees for most working professionals.

Tax-Loss Harvesting and Portfolio Rebalancing: A Natural Pair

Smart investors combine tax-loss harvesting with regular portfolio rebalancing.

Assume a target allocation of 70% stocks and 30% bonds. After a market run-up, the portfolio drifts to 80% stocks. Rebalancing means selling stocks to buy bonds.

Without tax awareness, an investor might sell the strongest performers first. That triggers the maximum capital gains tax.

The better approach: sell losers first. Harvest those losses. Use the proceeds to rebalance toward bonds. Same end result-better tax outcome.

Vanguard’s research indicates that tax-aware rebalancing can add 0. 40% to 0. 75% to after-tax returns annually, depending on the investor’s tax situation and turnover rate.

Common Mistakes to Avoid

**Harvesting losses in tax-advantaged accounts. ** IRAs and 401(k)s don’t benefit from tax-loss harvesting. Gains aren’t taxed within these accounts, so losses have no offsetting value. Focus harvesting efforts on taxable brokerage accounts only.

**Ignoring state taxes. ** Federal capital gains rates get most attention. But many states tax capital gains as ordinary income. California’s top rate hits 13 - 3%. New York City residents face a combined state/local rate approaching 12%. High-tax-state residents benefit more from harvesting.

**Forgetting about the cost basis reset. ** When you harvest a loss and buy a similar investment, your cost basis resets lower. This creates a larger embedded gain that you’ll eventually owe taxes on. Tax-loss harvesting is often tax deferral, not tax elimination.

That said, deferral has real value. A dollar saved today and invested beats a dollar paid in taxes. And if you hold until death, the step-up in basis eliminates the embedded gain entirely for your heirs.

**Over-trading. ** Some investors get so focused on harvesting that they generate excessive transaction costs or create unnecessarily complex portfolios. The tax tail shouldn’t wag the investment dog.

The Bottom Line

Tax-loss harvesting represents one of the few legitimate “free lunches” in investing. It won’t make you rich. It won’t compensate for poor investment decisions. But it can meaningfully improve after-tax returns over time.

The strategy works best when integrated into a broader, disciplined investment approach. Combine it with low-cost index funds, regular rebalancing, and a long-term perspective.

For most investors, the decision comes down to this: handle it yourself if you enjoy the process and have the time, or delegate to an automated service if you don’t. Either approach beats ignoring the opportunity entirely.

The math is straightforward. The execution requires attention to detail. A benefits compound for decades. That’s about as good as it gets in personal finance.