Tax-Loss Harvesting: How to Reduce Your Tax Bill

Tax-loss harvesting is one of the most powerful tax management strategies available to investors — and yet it's used by relatively few people outside of the wealthy and financially sophisticated. Here's how it works and how to implement it.

The Concept

Tax-loss harvesting involves selling an investment that has declined in value to realize a capital loss, which can then be used to offset capital gains (and reduce your tax bill), even though you remain invested in essentially the same assets immediately after.

How Capital Losses Save You Money

Capital losses can offset capital gains dollar-for-dollar. If you have $10,000 in capital gains and $7,000 in realized losses, you only owe tax on $3,000 in net gains. If your losses exceed gains, you can deduct up to $3,000 against ordinary income per year, with excess losses carried forward to future years.

The Wash-Sale Rule

The IRS prohibits a simple strategy of selling a security, claiming the loss, and immediately buying it back. The wash-sale rule disallows the loss if you buy the same or "substantially identical" security within 30 days before or after the sale. However, you can immediately buy a similar but not identical fund — selling the Vanguard S&P 500 ETF (VOO) and buying the iShares S&P 500 ETF (IVV), for example — maintaining your market exposure while realizing the tax loss.

When Does It Make Sense?

Tax-loss harvesting is most valuable for: investors in higher tax brackets (where capital gains rates are higher); taxable brokerage accounts (doesn't apply to 401(k)s or IRAs); years with significant capital gains income; and investors who have held diversified portfolios long enough to have some positions that have declined in value.

Automated Tax-Loss Harvesting

Robo-advisors like Betterment and Wealthfront offer automated tax-loss harvesting, continuously scanning your portfolio for harvesting opportunities. For high-balance taxable accounts, this service can potentially save thousands in taxes annually — potentially more than justifying the robo-advisor's fee.

Final Thoughts

Tax-loss harvesting doesn't eliminate taxes — it defers them and converts them from higher short-term rates to lower long-term rates. The real benefit is the compounding of the tax savings over time. If you have a taxable investment account, review it for harvesting opportunities, especially during market downturns when many positions may be temporarily in the red.