Investors naturally focus on growing their portfolios and capturing gains. But when certain investments decline in value, those losses may also create an opportunity to improve your overall tax position.
Tax-loss harvesting is an investment management strategy that involves selling an investment that has declined below its cost basis to realize the loss for tax purposes. The realized loss may then be used to offset capital gains and, subject to IRS limitations, potentially reduce taxable ordinary income.
Used thoughtfully, tax-loss harvesting can be one component of a broader investment and tax-planning strategy. However, it requires careful attention to investment objectives, portfolio allocation, tax rules, and the timing of transactions.
What Is Tax-Loss Harvesting?
Tax-loss harvesting involves selling an investment that is currently worth less than its original purchase price, thereby realizing a capital loss.
That realized loss can generally be used to offset capital gains from other investments. If your total capital losses exceed your capital gains, current IRS rules generally allow individuals to deduct up to $3,000 of net capital loss against ordinary income in a tax year, or $1,500 for married individuals filing separately. Unused capital losses may generally be carried forward to future tax years.
For example, imagine you sold one investment and realized a $15,000 capital gain during the year. You also own another investment that has declined by $9,000.
If the $9,000 loss is realized through a sale and the applicable tax rules are satisfied, that loss could offset $9,000 of the capital gain, leaving $6,000 of net capital gain from those transactions.
The strategy is not about selling investments simply because they have declined. Instead, the goal is to determine whether realizing a loss makes sense within the context of your overall portfolio and financial plan.
How Does Tax-Loss Harvesting Work?
A typical tax-loss harvesting strategy involves several steps:
1. Identify investments with unrealized losses
Your investment portfolio is reviewed to identify positions trading below their tax cost basis.
2. Evaluate whether realizing the loss makes sense
Not every investment loss should be harvested. The investment’s role in your portfolio, your asset allocation, expected future needs, transaction costs, and current and anticipated tax circumstances should all be considered.
3. Sell the investment
If harvesting is appropriate, the investment is sold and the loss becomes a realized capital loss for tax purposes.
4. Consider the tax impact
The realized loss may offset realized capital gains, subject to applicable tax rules. If net capital losses remain after offsetting gains, the IRS generally permits a limited deduction against ordinary income, with additional losses potentially carried forward.
5. Review the replacement investment
If maintaining market exposure is important, another investment may be considered. However, the replacement security must be evaluated carefully to avoid creating an unintended wash sale.
Understanding the Wash-Sale Rule
The wash-sale rule is one of the most important considerations when implementing tax-loss harvesting.
Generally, a wash sale occurs when you sell stock or securities at a loss and, within 30 days before or after the sale, acquire substantially identical stock or securities. The rule can also apply when substantially identical securities are acquired through certain options, contracts, or an IRA or Roth IRA.
If the wash-sale rules apply, the loss may be disallowed for current tax purposes. In many situations, the disallowed loss is instead added to the basis of the replacement investment, although special rules apply to securities acquired in an IRA or Roth IRA.
Why This Matters
Consider an investor who sells an ETF at a $5,000 loss and then purchases a substantially identical security shortly afterward.
The investor may have intended to capture the tax loss while remaining invested, but the transaction could trigger the wash-sale rules.
This is why tax-loss harvesting requires more than simply identifying investments that have declined. The timing and nature of both the sale and replacement investment matter.
Investors should also consider transactions across multiple accounts when evaluating potential wash sales.
Tax-Loss Harvesting Example
Suppose an investor has the following transactions during the year:
- Investment A: $15,000 realized capital gain
- Investment B: $9,000 unrealized capital loss
If Investment B is sold and the $9,000 loss is eligible to be recognized, the loss could offset $9,000 of the $15,000 gain.
The resulting net capital gain would be:
$15,000 gain − $9,000 loss = $6,000 net capital gain
The actual tax consequences will depend on factors such as the investor’s holding periods, other capital transactions, taxable income, filing status, and applicable federal and state tax rules.
This example is for illustration only and does not represent a tax calculation for any particular investor.
When Might Tax-Loss Harvesting Be Worth Considering?
Tax-loss harvesting may be particularly relevant for investors who:
- Hold investments in taxable brokerage accounts
- Have realized or expect to realize significant capital gains
- Are rebalancing a portfolio
- Are selling a concentrated stock position
- Have investments with meaningful unrealized losses
- Want to manage the tax consequences of portfolio changes
- Are coordinating investment decisions with a broader financial or tax plan
The strategy generally does not work the same way inside tax-deferred or tax-advantaged retirement accounts, where individual investment gains and losses typically aren’t recognized in the same manner as transactions in a taxable brokerage account.
Tax-Loss Harvesting Isn’t Just a Year-End Strategy
Tax-loss harvesting is often associated with the end of the calendar year, but potential opportunities can occur throughout the year.
Market volatility can create temporary declines in individual securities or asset classes even when an investor’s broader portfolio remains aligned with their long-term objectives.
Regular portfolio reviews can help identify whether realizing certain losses could make sense while maintaining an appropriate investment strategy.
However, harvesting should not become a reason to make unnecessary portfolio changes. Taxes are one consideration—not the sole reason to buy or sell an investment.
Tax-Loss Harvesting and Your Overall Financial Plan
Tax-loss harvesting works best when it is considered alongside the rest of your financial picture.
For example, an investment decision may also affect:
- Portfolio diversification
- Asset allocation
- Capital gains exposure
- Future liquidity needs
- Investment risk
- Estate planning
- Charitable giving
- Retirement planning
- Your broader tax situation
For that reason, tax-loss harvesting should generally be viewed as part of an integrated wealth management strategy rather than a standalone tax-saving tactic.
At Schmidt Wealth Management, investment decisions can be considered within the context of your broader financial goals and circumstances. When appropriate, coordination with your CPA or tax professional can help ensure investment strategies and tax planning are considered together.
Common Tax-Loss Harvesting Mistakes
Selling an investment solely because it has declined
A loss does not automatically mean an investment should be sold. The investment’s role in the portfolio and your long-term objectives should be considered first.
Ignoring the wash-sale rule
Purchasing substantially identical securities within the applicable 30-day window can result in the loss being disallowed.
Focusing only on federal taxes
State tax rules can differ from federal rules. Investors should consider their complete tax situation rather than focusing exclusively on federal capital gains treatment.
Forgetting about other accounts
Transactions involving substantially identical securities in other accounts—including certain IRA transactions—can affect wash-sale treatment.
Letting taxes drive the entire investment strategy
Tax efficiency matters, but it should be considered alongside risk, diversification, investment objectives, liquidity, and long-term financial goals.
A Strategic Approach to Tax-Loss Harvesting
Tax-loss harvesting is not about turning an unsuccessful investment into a successful one. It is about understanding how investment losses may be used within the tax rules while keeping your broader financial strategy on track.
The potential benefits can be meaningful, but the strategy also requires attention to the wash-sale rules, portfolio allocation, investment selection, transaction timing, and your individual tax circumstances.
If you have investments in taxable accounts and are unsure whether tax-loss harvesting could fit into your overall financial plan, a review of your portfolio may help identify areas worth discussing with your financial and tax professionals.
FAQs
What is tax-loss harvesting?
Tax-loss harvesting is a strategy in which an investor sells an investment that has declined below its tax cost basis to realize a capital loss. The realized loss may be used to offset capital gains, subject to applicable tax rules.
How much capital loss can I deduct each year?
If your capital losses exceed your capital gains, the IRS generally allows individuals to deduct up to $3,000 of net capital loss against ordinary income per year, or $1,500 if married filing separately. Additional unused losses can generally be carried forward to future tax years.
What is the wash-sale rule?
The wash-sale rule generally applies when you sell stock or securities at a loss and acquire substantially identical stock or securities within 30 days before or after the sale. When the rule applies, the loss may not be deductible immediately.
Can I buy the same investment back after tax-loss harvesting?
You need to consider the wash-sale rules before repurchasing the same or a substantially identical security. The relevant window generally extends 30 days before and 30 days after the sale.
Does tax-loss harvesting work in an IRA?
Tax-loss harvesting generally isn’t used in the same way inside an IRA or Roth IRA because gains and losses from individual transactions aren’t generally recognized for current tax purposes as they are in a taxable brokerage account. In addition, the IRS specifically addresses acquisitions of substantially identical securities in an IRA or Roth IRA under the wash-sale rules.
Do I have to wait until December to harvest losses?
No. Potential tax-loss harvesting opportunities can arise throughout the year. Market movements, portfolio rebalancing, and changes in an investor’s financial circumstances can all create situations worth reviewing.
Can tax-loss harvesting reduce my taxes every year?
It can potentially provide tax benefits in a particular year, but there is no guarantee that harvesting losses will reduce your overall tax liability every year. The value of the strategy depends on factors including realized gains, losses, income, investment decisions, and applicable tax rules.
Should I sell an investment just to create a tax loss?
Not necessarily. Tax considerations are only one factor in an investment decision. Selling an investment should also be evaluated in relation to your portfolio allocation, risk tolerance, financial goals, and long-term investment strategy.
Is tax-loss harvesting the same as tax preparation?
No. Tax-loss harvesting is an investment and tax-planning strategy. Your CPA or tax professional is responsible for tax preparation and filing. Coordination between your investment advisor and tax professional can help ensure the strategy is considered appropriately within your broader financial situation.
