Key Takeaways
- Tax loss harvesting lets you offset capital gains with investment losses
- You can deduct up to $3,000 in net losses against ordinary income annually
- Unused losses carry forward indefinitely to future tax years
- The wash sale rule prevents repurchasing the same security within 30 days
- Strategic harvesting can save thousands in taxes over your investment lifetime
What Is Tax Loss Harvesting?
Tax loss harvesting is an investment strategy that involves selling securities at a loss to offset capital gains taxes. When you sell investments for less than you paid, you realize a capital loss that can be used to reduce your tax liability on gains from other investments.
This strategy is particularly valuable during market downturns or when rebalancing your portfolio. Instead of viewing losses as purely negative, savvy investors recognize them as opportunities to reduce their overall tax burden.
How Tax Loss Harvesting Works
The basic process involves three steps:
- Identify underperforming investments in your taxable accounts that have declined in value
- Sell those investments to realize the capital loss
- Use the loss to offset capital gains or up to $3,000 of ordinary income
Pro Tip: Maintain Market Exposure
After selling a losing position, consider purchasing a similar (but not "substantially identical") investment to maintain your market exposure while still capturing the tax benefit. For example, sell an S&P 500 ETF and buy a total market fund.
The Wash Sale Rule
The IRS imposes the wash sale rule to prevent investors from claiming artificial losses. This rule disallows the loss deduction if you purchase a "substantially identical" security within 30 days before or after the sale.
Watch Out for Wash Sales
The wash sale rule applies across all your accounts, including your spouse's accounts and retirement accounts like IRAs. Purchasing the same stock in your 401(k) within 30 days can trigger a wash sale in your taxable account.
Short-Term vs. Long-Term Losses
Capital gains and losses are categorized based on how long you held the investment:
- Short-term: Held 1 year or less - taxed at ordinary income rates (up to 37%)
- Long-term: Held more than 1 year - taxed at preferential rates (0%, 15%, or 20%)
Short-term losses first offset short-term gains, and long-term losses first offset long-term gains. Net losses of either type can then offset the other type.
Annual Limits and Carryforward
If your capital losses exceed your capital gains, you can deduct up to $3,000 ($1,500 if married filing separately) against ordinary income. Any remaining losses carry forward to future tax years indefinitely.
When to Harvest Losses
Consider tax loss harvesting when:
- Markets have declined significantly
- You're rebalancing your portfolio anyway
- You have large realized capital gains to offset
- You want to reduce your taxable income
- You're in a high tax bracket this year
Year-End Planning
Review your portfolio in November and December for tax loss harvesting opportunities. This gives you time to realize losses before year-end while avoiding wash sales by January 1st.