Tax-loss harvesting (TLH) means selling an investment at a loss to realize that loss for tax purposes, then immediately buying a similar (but not identical) investment to maintain market exposure. The realized loss offsets capital gains or income, reducing your tax bill.
How the Tax Math Works
- •You sell Stock A for a $10,000 loss. You buy Stock B (similar sector/index) immediately.
- •That $10,000 loss offsets $10,000 of capital gains elsewhere in your portfolio
- •In the 20% long-term capital gains bracket: saves $2,000 in taxes
- •If losses exceed gains: Up to $3,000/year can offset ordinary income. Excess carries forward indefinitely.
The Wash-Sale Rule: The Key Constraint
You cannot repurchase the "substantially identical" security within 30 days before or after the sale. If you sell VTI (Vanguard Total Market) at a loss and buy VTI back 15 days later, the IRS disallows the loss. Solution: Buy a different but correlated ETF — e.g., sell VTI, buy ITOT (iShares equivalent) — same exposure, different fund, no wash sale.
When Tax-Loss Harvesting Is Worth It
- •You have taxable brokerage accounts (TLH doesn't apply in IRAs/401ks — no capital gains inside them)
- •You're in the 22%+ tax bracket (lower brackets may pay 0% on long-term gains anyway)
- •You have realized or expected capital gains to offset
- •Market has declined — losses to harvest exist
Robo-advisors like Betterment and Wealthfront do automated daily tax-loss harvesting. For large taxable accounts ($100,000+), the annual tax savings often justifies their 0.25% fee. For smaller accounts, manual harvesting during significant market dips is sufficient.
TLH defers taxes, not eliminates them. When you sell the replacement investment later, your cost basis is lower (because you harvested the loss), so you'll owe more tax then. The benefit is the time value of money — paying $2,000 in tax in 10 years is worth less than paying it today.