Key Takeaways
- Tax-loss harvesting lets you strategically sell underperforming investments to reduce your tax liability without abandoning your long-term investment plan.
- You can use realized capital losses to offset capital gains and up to $3,000 of ordinary income per year, with unused losses carried forward.
- Reinvesting in a similar (but not substantially identical) investment lets you stay invested while still capturing tax benefits, as long as you avoid the wash-sale rule.
- Tax-loss harvesting is most effective within taxable investment accounts and doesn’t apply to tax-deferred retirement plans like IRAs or 401(k)s.
- A tax-aware investment strategy — including harvesting losses — can be a powerful way to enhance long-term, risk-adjusted, after-tax portfolio growth when coordinated with broader tax planning.
What Is Tax-Loss Harvesting?
The idea of tax-loss harvesting may sound counterintuitive — after all, the process involves selling investments that are down to lock in a loss, and the standard investment mantra is “buy low, sell high.” Yet as odd as it may seem to intentionally realize investment losses, tax-loss harvesting is an important tax planning strategy that shouldn’t be overlooked.
Tax-loss harvesting is a tax-smart investment strategy that helps reduce your taxable income by selling securities at a loss and using that loss to offset capital gains. This tactic applies specifically to taxable investment accounts, like brokerage accounts, and doesn’t apply to tax-deferred retirement plans, like IRAs or 401(k)s.
You trigger a capital gain when you sell an asset for more than you paid for it (your cost basis). But if another investment in your portfolio has declined, selling it at a loss can help offset these gains and reduce your overall tax liability. At the end of the year, your net capital gain — or loss — is calculated by subtracting your capital losses from your capital gains. If your losses exceeded your gains, you can generally deduct up to $3,000 per year against ordinary income and carry forward any additional losses for future years.
Tax-loss harvesting can help you stay in the market while you do this. You can reinvest the proceeds from the sale into a similar but not “substantially identical” investment so that your portfolio’s risk exposure and growth potential remain aligned with your long-term strategy.
How Does Tax-Loss Harvesting Work in Practice?
Imagine you sell a stock that generated a $10,000 profit. This gain would typically be subject to capital gains tax. But if you also sell a different holding that’s down $6,000, you’ll only owe tax on the $4,000 net gain.
If you had no gains this year but sold a losing investment for a $3,000 loss, you could use that amount to reduce your taxable income (potentially saving several hundred dollars, depending on your tax bracket). And if your net capital loss is larger than $3,000, you can generally carry the unused portion forward and use it in future years.
To help keep your investment strategy on track, you’d typically:
- Identify securities in your taxable portfolio with unrealized losses
- Sell those positions to realize the loss
- Immediately reinvest in similar, but not substantially identical, securities to maintain market exposure and asset allocation
Over time, this disciplined process can help you pursue your financial goals while limiting the drag of taxes on your returns.
Key Rules: The Wash-Sale Rule and Other Considerations
The wash-sale rule
When implementing a tax-loss harvesting strategy, you need to be aware of the IRS’ wash-sale rule. This rule is intended to prevent investors from selling at a loss solely to obtain a tax deduction while effectively maintaining the same investment exposure.
The wash-sale rule is triggered when you:
- Sell an investment at a loss and, within 30 days before or after the sale, buy back a “substantially identical” security
- Have your spouse or a company you control buy a substantially identical security in the 30 days before or after the sale
- Sell at a loss in a taxable account, then buy the same or a substantially identical security in a tax-advantaged account (such as an IRA) in the 30 days before or after the sale
If your transaction triggers the wash-sale rule, the loss is disallowed for current tax purposes. Instead, it’s generally added to the cost basis of the new shares, potentially reducing your taxable gain (or increasing a future loss) when you sell those replacement shares.
Because of this, many investors turn off automatic dividend reinvestments in taxable accounts and coordinate all trading across their accounts before harvesting losses.
Offsetting capital gains and ordinary income
One of the key advantages of tax-loss harvesting is the ability to reduce your capital gains taxes. Investors can use realized losses to offset capital gains; the amount you can apply against other income is generally the lesser of $3,000 or your total net loss in a given year. If the net capital loss exceeds the limit, you can carry it forward to future years.
This strategy becomes especially useful in years with significant gains from stock sales, business exits or real estate transactions. When you deliberately harvest losses, you may be able to fully or partially neutralize these gains and reduce your total tax bill.
Benefits of Tax-Loss Harvesting
Understanding how tax-loss harvesting works is just the beginning. The real value lies in the tangible benefits you can enjoy when you thoughtfully integrate this technique into your broader investment strategy.
Reduced tax liability and improved after-tax returns
One of the most immediate advantages is the potential reduction of your taxable income. Harvesting investment losses to offset capital gains (or up to $3,000 in ordinary income) lets you minimize your current tax liability and keep more of your returns working for you. Over time, these savings can compound when reinvested, contributing to long-term portfolio growth.
Tax-loss harvesting doesn’t change your underlying investment risk by itself, but when it’s combined with disciplined portfolio management, it can help improve your after-tax risk-adjusted returns. For example, you can use harvested losses to offset gains created by rebalancing or trimming highly appreciated positions while still maintaining a diversified, long-term allocation.
Strategic flexibility in high-tax years
Tax-loss harvesting also offers strategic flexibility. If you’re expecting a higher tax year — perhaps because of a business windfall, property sale or bonus — harvesting losses during market dips can give you more control over your tax bracket.
Similarly, in years when capital gains are elevated, tax-loss harvesting offers a way to smooth the impact and better align your tax bill with your long-term investment timeline.
Part of a broader tax-efficient plan
When used as part of a broader, tax-efficient planning approach, tax-loss harvesting complements other strategies — like identifying overlooked tax deductions, optimizing withdrawals or structuring charitable gifts — to create a comprehensive plan tailored to your goals.
You can read our article, How Tax-Efficient Is Your Portfolio? to learn more about how we think about tax-efficient asset location, withdrawals and portfolio construction.
Tax-Loss Harvesting Tips
Understanding how tax-loss harvesting works means knowing the IRS rules that govern it — and the missteps that could cost you a valuable deduction. From offsetting capital gains to observing deadlines, these tips can help you execute your strategy with confidence.
Focus on taxable accounts
Tax-loss harvesting is most effective in taxable brokerage accounts where capital gains and losses are recognized. It generally doesn’t apply to retirement accounts like IRAs or 401(k)s, where gains and losses are sheltered from current taxation.
Watch state-specific rules
While federal tax laws govern the basics of capital gains and losses, state-level rules can differ. Some states don’t allow capital losses to offset ordinary income or may limit carryforwards. Because of these differences, it’s important to coordinate with a tax advisor who understands both federal and state-specific tax laws, especially if you plan to relocate or already file in multiple states.
Mind the calendar
You must complete and settle all tax-loss harvesting trades by December 31 for them to count toward that tax year. Because most trades take two business days to settle, waiting until the last week of December can leave you vulnerable to market closures, volatility or processing delays.
Instead of treating tax-loss harvesting as a last-minute task, we typically look for opportunities throughout the year to capture losses during periods of volatility. This year-round approach can create more consistent opportunities to improve tax efficiency.
Tax-Loss Harvesting Examples
As an example, consider Joan Investor, whose income places her in the 37% income tax bracket and whose capital gains tax rate is 20%. Joan has the following unrealized gains and losses within her investment portfolio:
- Stock A – Held for 652 days, unrealized gain of $250,000 (long-term)
- Stock B – Held for 556 days, unrealized loss of $150,000 (long-term)
- Stock C – Held for 95 days, unrealized loss of $80,000 (short-term)
Joan completes the following trades throughout the year:
- Stock D – Sold for a realized gain of $200,000 after holding for 425 days (long-term capital gain)
- Stock E – Sold for a realized gain of $120,000 after holding for 125 days (short-term gain, taxable as ordinary income)
Without tax-loss harvesting, Joan would owe:
- $40,000 in tax on the long-term gain ($200,000 × 20%)
- $44,400 in tax on the short-term gain ($120,000 × 37%)
- A total tax liability of $84,400
If Joan instead decides to realize the losses in Stocks B and C, she could offset a substantial portion of her gains:
- Long-term: $200,000 gain – $150,000 loss = $50,000 net long-term gain ($10,000 tax at 20%)
- Short-term: $120,000 gain – $80,000 loss = $40,000 net short-term gain ($14,800 tax at 37%)
Her total tax bill drops to $24,800 — a tax savings of $59,600. This is a clear example of how thoughtful tax-loss harvesting can help create a more tax-efficient portfolio.
However, if Joan repurchases a “substantially identical” stock within 30 days, the wash-sale rule will disallow the losses.
FAQs on Tax-Loss Harvesting
What are common strategies for tax-loss harvesting?
Common strategies often start with regular portfolio monitoring, especially during volatile periods. Investors might identify positions that have declined below their cost basis and sell them to realize a capital loss, then reinvest the proceeds into a similar asset to maintain market exposure without triggering the wash-sale rule.
Some investors adopt a year-round harvesting approach, pairing short-term losses and gains to offset income taxed at higher rates rather than waiting until year-end.
Is tax-loss harvesting worth it?
Tax-loss harvesting may offer meaningful value for some investors, particularly those in higher tax brackets with significant assets in taxable accounts. By using investment losses to offset gains and reduce ordinary income, you may lower your annual tax bill without derailing your portfolio strategy.
Whether it’s worth it depends on your specific situation — including your account types, income level, investment goals and tax exposure — as well as trading costs and the complexity of your portfolio. Tax-loss harvesting works most efficiently when integrated into a broader plan to create a tax-efficient portfolio and support long-term growth.
How Tax-Loss Harvesting Fits Into a Broader Tax-Efficient Strategy
Tax-loss harvesting is just one piece of a larger tax-efficient investing puzzle. It works best alongside:
- Asset location decisions that place tax-inefficient investments in tax-deferred accounts and tax-efficient investments in taxable accounts
- Retirement income strategies that coordinate withdrawals across taxable, tax-deferred and tax-free accounts
- Charitable giving or gifting strategies that can use appreciated securities to further reduce tax exposure
You can read our article on the pros and cons of a zero-tax retirement to see how we think about tax-efficient retirement planning.
If you’d like proactive, year-round guidance, you can learn more about our tax planning services.
Help Maximize Your Tax Savings With Creative Planning
Tax-loss harvesting is just one part of a comprehensive strategy to reduce tax liability and grow your wealth. At Creative Planning, we take a proactive, personalized approach to tax planning; we help clients understand how tax-loss harvesting works and where it fits within their broader financial picture.
