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Tax-Loss Harvesting Basics

What Is Tax-Loss Harvesting?

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What Is Tax-Loss Harvesting?

Tax-loss harvesting is the practice of selling securities at a loss to reduce your taxable capital gains and ordinary income. You crystallize a loss on paper, use it to shelter gains from earlier sales (or current year income up to $3,000 per year), and reinvest the proceeds in a similar but not identical security to maintain your asset allocation. It is one of the few genuinely free tax moves available to non-professional investors.

Key takeaways​

  • Selling at a loss generates a capital loss that offsets capital gains dollar-for-dollar, plus up to $3,000 of ordinary income annually.
  • Tax-loss harvesting works only in taxable accounts; retirement accounts are tax-deferred, so losses are useless.
  • The strategy requires discipline: you must avoid repurchasing substantially identical securities within 30 days (or 61 days across the wash-sale window) to stay compliant with IRS rules.
  • Substitute funds (same sector, different issuer) let you maintain your target allocation while harvesting losses without forced market timing.
  • The math often justifies the complexity for investors with six-figure taxable accounts and significant gains, but is marginal for smaller portfolios or those in low tax brackets.

How capital losses reduce your tax bill​

When you realize a capital loss in a taxable brokerage account, the IRS allows you to use that loss to offset capital gains from the same tax year. If you sold a mutual fund for a $5,000 gain in March and another holding for a $3,000 loss in September, your net taxable gain is $2,000. You owe tax on the spread, not the full gain.

If losses exceed gains in a given year, the IRS permits you to deduct up to $3,000 of those excess losses against ordinary income (wages, interest, dividends). A $10,000 loss with no offsetting gains lets you shield $3,000 of wages or other income from tax; the remaining $7,000 loss carries forward indefinitely to future years. This creates a durable tax shield. An investor in the 24% tax bracket saves $720 in federal tax on that $3,000 deduction alone (before state taxes). For high-income earners, the math can be compelling.

Who actually cares about TLH​

The strategy is most effective for investors with all three characteristics:

  1. A substantial taxable account. You need enough capital and sufficient gains (or income) to harvest against. Harvesting a $1,000 loss to shelter $1,000 of income at the 22% bracket saves $220 in federal tax — respectable, but only if the harvesting itself doesn't trigger transaction costs or tax complexity that swallows the gains.

  2. Realized capital gains or high ordinary income. You might harvest losses if you sold winners earlier in the year or expect a large bonus or deferred compensation payout. If you have no gains and low income, the $3,000 ordinary income deduction is your ceiling; it still counts, but the benefit is smaller.

  3. A time horizon long enough to wait out the 30-day window. Tax-loss harvesting requires that you not repurchase a substantially identical holding within 30 days before or after the sale. If you need the exact security back immediately, this rule breaks the strategy.

TLH is not a windfall; it's arithmetic​

Tax-loss harvesting does not create wealth from nothing. When you sell an investment at a loss, you lock in that real loss. The tax benefit merely recovers a percentage of your economic loss — the percentage being your marginal tax rate. If you lose $10,000 in real terms and harvest the loss at a 24% marginal rate, the tax deduction saves you $2,400. You are still $7,600 worse off. The strategy is salvaging some of the damage, not erasing it.

This is why timing matters. You want to harvest losses when you are in a high tax bracket (or expecting significant gains) so that the tax rate applied to your loss is as high as possible. An investor in the 12% bracket saves only $1,200 on a $10,000 loss; the same loss is worth $2,400 to someone in the 24% bracket and $3,700 to a 37% earner in a high-income year.

Practical mechanics at a high level​

The basic sequence is:

  1. Monitor your taxable holdings for losses as the year progresses.
  2. When a position falls below your cost basis and you have gains to offset (or high income), sell the loser.
  3. Immediately buy a similar but not identical replacement (typically an ETF or fund in the same asset class but from a different issuer).
  4. Maintain this substitute position for at least 30 days, then return to your original holding if you prefer, or stay with the substitute if it is equally tax-efficient.
  5. Repeat across the calendar year.

The discipline and paperwork required — tracking cost basis, remembering the 30-day rule, managing multiple positions across accounts — make this strategy unsuitable for passive investors who rebalance once a year. But for active taxable investors or those with substantial realized gains, the tax savings often justify the overhead.

Decision tree​

Next​

The first step in harvesting is understanding how to execute the sale and track your cost basis correctly. Next, we examine the mechanics of realizing a loss and how different account types handle capital gains differently.