Tax-loss harvesting basics

When the market drops, most people do one of two things: panic-sell or do nothing. There’s a third option that most people miss — sell the loser, immediately buy something equivalent, and bank the loss as a tax deduction while staying fully invested.

That’s tax-loss harvesting. The loss reduces your tax bill. The replacement investment keeps you in the market. Net result: you’re in roughly the same investment position, but you’ve generated a tax deduction that offsets gains elsewhere — or up to $3,000 per year of ordinary income.

A concrete example

You invest $10,000 in VOO (an S&P 500 ETF). The market drops 15% and your position is now worth $8,500. You have a $1,500 unrealized loss.

You sell VOO and simultaneously buy VTI (a Total Market ETF that closely tracks the same market). Your investment position is essentially unchanged — you own a broad US equity index.

But you’ve now realized a $1,500 capital loss. If you’re in the 22% federal bracket and your state taxes gains at 5%, that loss saves you roughly $405 in taxes ($1,500 × 27%).

That $405 savings compounds. Reinvested at 7% for 25 years, it becomes $2,196. Not life-changing on its own, but this is the kind of thing that adds up across a career.

Using losses to offset gains

Capital losses first offset capital gains dollar for dollar:

1. Short-term losses offset short-term gains
2. Long-term losses offset long-term gains
3. Remaining losses of each type can cross-offset the other type
4. Up to $3,000 in net losses can offset ordinary income per year
5. Any unused losses carry forward to future years indefinitely

The most valuable use of harvested losses is offsetting capital gains from the same year. If you sold appreciated stock, a bond fund, or a rental property with a large gain, harvested losses cancel that gain and eliminate the tax entirely.

The $3,000 ordinary income deduction is useful but modest. For someone in the 24% bracket, $3,000 saves $720. The real payoff comes from harvesting losses large enough to offset significant gains.

The wash-sale rule — do not violate this

The IRS’s wash-sale rule disallows a loss if you buy a “substantially identical” security within 30 days before or after the sale.

Disallowed: Sell VOO at a loss, buy VOO 5 days later. The loss is denied; your basis in the new shares is adjusted to preserve it for later — but you’ve lost the immediate tax benefit.

Allowed: Sell VOO at a loss, buy VTI or ITOT immediately. Different ETF, similar exposure, no wash sale.

The 30-day window applies symmetrically — 30 days before the sale also counts. If you bought additional VOO 20 days ago, selling today triggers a partial wash sale on those new shares.

What counts as “substantially identical” is not exhaustively defined by the IRS, but here’s the practical read:

• Two ETFs tracking the same index from different providers are generally similar but not identical (S&P 500 ETFs from different fund families should be fine)
• Two funds tracking the exact same index from the same provider are riskier — avoid rotating between IVV and VOO
• An S&P 500 fund and a Total Market fund are clearly not substantially identical

When in doubt, rotate into a broader or different index. The goal is maintaining similar market exposure, not identical exposure.

When tax-loss harvesting makes sense

High-income years. The higher your tax bracket, the more each dollar of loss is worth. In the 37% bracket, a $10,000 harvested loss saves $3,700+ in federal taxes alone.

Years with large capital gains. Harvesting losses to offset a large one-time gain — a stock sale, real estate sale, business sale — is the highest-value application. This is the part most people miss.

Market downturns. Any significant market correction creates harvesting opportunities across a diversified portfolio. The 2020 COVID crash and 2022 rate-hike correction were rich harvesting environments.

Taxable accounts only. Capital gains don’t apply inside 401(k)s, IRAs, or HSAs. Harvesting only makes sense in taxable brokerage accounts.

What tax-loss harvesting is not

Not market timing. You immediately reinvest in a similar asset. Your market exposure is maintained throughout. You’re not predicting a continued drop or making a directional bet.

Not a free lunch. When you harvest a loss, your new position has a lower cost basis. That lower basis means a larger taxable gain when you eventually sell. Harvesting defers and converts taxes — it doesn’t eliminate them, except in cases where the asset is held until death (stepped-up basis) or donated to charity.

Not worth doing manually at scale. Manually tracking lots across dozens of positions is tedious and error-prone. Robo-advisors like Betterment and Wealthfront automate daily tax-loss harvesting across your entire portfolio. For large taxable accounts, the automation may justify their fee.

The actual value: deferral plus reinvestment

The core value proposition of tax-loss harvesting is the time value of deferred taxes. Deferring $1,000 in taxes for 20 years at 7% growth is worth about $2,870 in future value — you didn’t save the $1,000, but you used it for 20 years as if it were yours.

For high-income investors with large taxable portfolios and frequent rebalancing, systematic tax-loss harvesting can add 0.2–0.5% of additional net annual return. Over decades, that compounds meaningfully.

For someone with a $50,000 taxable account and no significant gains to offset, the annual benefit is modest enough that the time spent tracking it may not be worthwhile. Know which camp you’re in before getting obsessive about this.

Further reading

• Understanding capital gains tax — the foundational context: short vs. long-term rates, wash sales, and state taxes
• 401k vs. Roth calculator — which account type minimizes lifetime tax on investment gains
• IRS: Topic No. 409, Capital Gains and Losses — authoritative source on the wash-sale rule and loss carryforward