Tax-Loss Harvesting Explained: Turning a Loss Into a Deduction

Tax-loss harvesting means deliberately selling an investment that is worth less than you paid for it. That locks in the loss on paper so it can offset taxes owed elsewhere. Selling at a loss on purpose sounds backwards. But in a taxable account it is a legitimate way to reduce a tax bill using a downturn that already happened.

How it actually works

When an investment is sold for less than its purchase price, that is a capital loss. Capital losses first offset capital gains from other investments sold at a profit in the same year, dollar for dollar. If losses exceed gains, up to $3,000 of the remaining loss can offset ordinary income, like salary, in that tax year. Anything beyond that carries forward to future years indefinitely. See Capital Gains Tax Explained for how gains themselves get taxed.

A simple example

Say someone has $5,000 in capital gains from selling one investment and a separate investment currently down $5,000. They could sell the losing position, harvesting a $5,000 loss that fully offsets the $5,000 gain. That reduces that year's capital gains tax to zero on those trades. The proceeds from the sale can then be reinvested, often into something similar but not identical, to stay invested in the market.

The wash sale rule

This is the rule that trips people up. The IRS disallows the tax loss if you buy the same, or a "substantially identical," security within 30 days before or after the sale. That is called a wash sale. Selling a losing stock and buying it right back to harvest the loss does not work, because the loss gets disallowed. The common workaround is reinvesting the proceeds into a similar but not identical fund. For example, you sell one S&P 500 ETF and buy a different, comparable total-market ETF. You stay invested with similar market exposure without violating the rule.

Where it does and does not apply

Tax-loss harvesting only matters in a taxable brokerage account. It is irrelevant in a 401(k) or IRA. Gains and losses inside tax-advantaged accounts are not taxed year to year in the first place, so there is nothing to harvest. It is also irrelevant if there is no capital gain or ordinary income to offset. Though the $3,000-a-year ordinary income offset and the unlimited carryforward mean it is rarely completely useless when a real loss exists.

Is it worth the effort

For a small taxable account with modest losses, the tax savings may be minor and not worth obsessing over. For a larger taxable portfolio, especially during a broad market downturn when many positions are showing paper losses, it can meaningfully reduce a tax bill. The cost is some bookkeeping and a reinvestment decision. Several robo-advisors now automate this process entirely, watching for harvestable losses and executing them automatically within the wash sale rules. The best window is often December. It is a standard item on the year-end tax checklist.

The mindset shift

Tax-loss harvesting reframes a market downturn from purely bad news into partially useful news. A loss you were going to experience on paper anyway, if you were holding through the dip regardless, can at least do some work. It reduces what is owed elsewhere. It is not a reason to sell an investment you would otherwise keep. For a position already being exited or replaced, though, it is a detail worth not leaving on the table.

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This article is for general educational purposes only and does not constitute personal financial, investment, tax, or legal advice. Consult a qualified financial professional before making major financial decisions. See our Disclaimer.