What is tax-loss harvesting

In the stock market, even a loss can be turned into a win. Tax-loss harvesting is the process of using market downturns to lower your IRS bill.

Close up of a 1040 tax form and a falling red arrow chart

Turning Red into Green

When you sell an investment that has lost value, you create a Capital Loss. You can use these losses to 'offset' any capital gains you made. If you sold Apple for a $5,000 profit but sold Disney for a $5,000 loss, your net gain is zero and you owe **zero capital gains tax**. If your losses exceed your gains, you can even use up to $3,000 of 'extra' losses to lower your regular income tax. Any losses beyond that can be 'carried forward' to future tax years. This effectively makes the government share in your investment risk.

The 'Wash Sale' Rule

You cannot 'harvest' a loss and then immediately buy the same stock back. The IRS's Wash Sale Rule states that if you buy a 'substantially identical' security within 30 days before or after the sale, the loss is disallowed for tax purposes. To stay invested in the market while harvesting the loss, you must buy a similar but not identical asset. For example, if you sell an S&P 500 Index Fund (like VOO), you might buy a 'Total Stock Market' Index Fund (like VTI). They are correlated but not 'substantially identical,' allowing you to capture the tax benefit without missing out on the market's recovery.

When to Harvest

December Checkup: Most investors look for harvesting opportunities at the end of the year to prep for tax season.
Market Crashes: A sudden market dip is a great time to 'bank' dozens of years worth of losses that can be used to offset future gains.
Automated TLH: Many 'Robo-Advisors' (like Betterment or Wealthfront) perform tax-loss harvesting automatically for you, sometimes adding 1% or more to your after-tax annual returns.

Maintenance for Wealth

Tax-loss harvesting only applies to taxable brokerage accounts. There is no benefit to doing this in an IRA or 401(k), because gains and losses in those accounts aren't taxed annually. For high-earning individuals, a disciplined TLH strategy can be the difference between a 'good' return and a 'great' after-tax result over 20+ years.

Real Life Examples

Mrs. Williams

Teacher • $60k Income • 20% Savings Rate

Mrs. Williams used tax-loss harvesting during the 2022 market dip. She 'banked' enough losses to offset all her dividends for the next three years, saving her over $2,000 in taxes.

Mr. Johnson

Project Manager • $90k Income • 10% Savings Rate

Mr. Johnson doesn't want to see 'red' in his account, so he refuses to sell even at a loss. He misses the opportunity to lower his tax bill because of an emotional attachment to his original price point.

Mr. Smith

Sales Executive • $120k Income • 5% Savings Rate

Mr. Smith tried to harvest a loss but bought the same stock back two days later. The IRS disallowed his loss, and he still had to pay full taxes on his other gains.