Tax-Loss Harvesting: Rules and Strategies for Smart Investing
CORE INSIGHTS
- Tax Efficiency: TLH is a strategy to use investment losses to offset realized capital gains, legally reducing your tax bill.
- The $3,000 Rule: If your losses exceed your gains, you can deduct up to $3,000 per year against ordinary income (e.g., wages).
- The Wash Sale Trap: The IRS forbids buying the same or a “substantially identical” security 30 days before or after selling it for a loss.
Tax-Loss Harvesting (TLH) is a powerful, year-end strategy that helps long-term investors turn a market downturn into a tax advantage. Instead of ignoring losses in your taxable brokerage account, TLH formalizes the process of selling underperforming assets to reduce your overall capital gains liability.
The $10,000 Tax Savings Scenario:
Imagine you realized $10,000 in capital gains this year.
• You then harvest $10,000 in losses.
• Result: Your net capital gain is $0. If you are in the 15% long-term capital gains bracket, you saved $1,500 in taxes.
The best part: Any remaining loss carries forward to future years, continuing your tax optimization.
Imagine you realized $10,000 in capital gains this year.
• You then harvest $10,000 in losses.
• Result: Your net capital gain is $0. If you are in the 15% long-term capital gains bracket, you saved $1,500 in taxes.
The best part: Any remaining loss carries forward to future years, continuing your tax optimization.
Visualizing the Financial Benefits
The chart below illustrates the two primary financial benefits of executing a TLH strategy: reducing your current year’s capital gains tax and providing an ordinary income deduction.
*Illustrative data based on a scenario where $10,000 in losses are used to offset gains and deduct from ordinary income. Actual tax savings depend on your bracket.*
The Critical Wash Sale Rule
| Rule Component | Definition | Example to Avoid |
|---|---|---|
| The 61-Day Window | The 30 days before the sale and the 30 days after the sale. | Selling VTI on Dec 1st and buying VTI back on Dec 15th. |
| “Substantially Identical” | Buying an asset that is extremely similar to the one you sold. | Selling VOO and immediately buying IVV (both S&P 500). |
| Wash Sale via IRA | Buying the same stock in an IRA triggers the wash sale, too. | Selling in taxable for a loss, buying in Roth IRA 2 weeks later. |
Strategic Action Steps
1
Identify Losers in Your Taxable Account
TLH only works in a taxable brokerage account. Identify assets that are currently trading below your original purchase price.
TLH only works in a taxable brokerage account. Identify assets that are currently trading below your original purchase price.
2
Find a “Similar but Different” Replacement
To avoid the Wash Sale rule, sell your losing stock/ETF and immediately purchase a similar (but not identical) asset (e.g., sell Total Market, buy Large Cap).
To avoid the Wash Sale rule, sell your losing stock/ETF and immediately purchase a similar (but not identical) asset (e.g., sell Total Market, buy Large Cap).
3
Plan for the $3,000 Limit
If your realized losses exceed your gains, you can only deduct up to $3,000 against ordinary income per year. Excess loss carries forward.
If your realized losses exceed your gains, you can only deduct up to $3,000 against ordinary income per year. Excess loss carries forward.
The Bottom Line: Who Should Harvest Losses?
- Yes, if: You have realized capital gains from selling other investments this year, or you need the $3,000 ordinary income deduction.
- No, if: You only invest in retirement accounts (401k/IRA), or you have not generated any capital gains.
Frequently Asked Questions
Q. What is the primary benefit of Tax-Loss Harvesting?
The primary benefit of TLH is reducing current or future capital gains tax liability by realizing investment losses. If realized losses exceed gains, you can also deduct up to $3,000 against ordinary income per year.
Q. What is the Wash Sale Rule?
The Wash Sale Rule is an IRS rule preventing investors from claiming a tax deduction if they purchase the same or a ‘substantially identical’ security within 30 days before or after the sale that realized the loss.
Q. Can I use TLH in my IRA or 401(k)?
No. Tax-loss harvesting only applies to investments held in taxable brokerage accounts. Gains and losses within tax-advantaged retirement accounts like IRAs or 401(k)s do not impact your annual tax return.
Disclaimer: This article is for educational purposes only. Tax-Loss Harvesting rules are complex and dependent on individual tax brackets and holdings. Consultation with a qualified tax professional is strongly recommended before executing a TLH strategy.