The Short Answer

Tax-loss harvesting is the practice of selling an investment in a taxable account that has declined in value to realize a capital loss, then reinvesting the proceeds in a similar but not substantially identical investment to maintain your market exposure. The realized loss can offset capital gains and, if losses exceed gains, up to $3,000 of ordinary income per year, with unused losses carried forward indefinitely. Harvesting can be valuable, but it must comply with the wash-sale rule and should be evaluated within your broader tax and investment plan.

How Does Tax-Loss Harvesting Work?

Suppose you own a fund that has fallen below what you paid for it. By selling it, you realize a loss you can use for tax purposes. To avoid stepping out of the market, you immediately purchase a different investment with similar characteristics, such as a fund tracking a different but comparable index. Your portfolio’s risk and return profile remains largely unchanged, while you have captured a tax asset.

Realized losses first offset capital gains of the same type, short-term against short-term and long-term against long-term, and then other gains. Net losses can offset up to $3,000 of ordinary income per year, and any remaining losses carry forward to future years.

What Is the Wash-Sale Rule?

The IRS disallows a loss if you buy a “substantially identical” security within 30 days before or after the sale. This applies across your accounts, including IRAs and, in many cases, a spouse’s accounts. A purchase through automatic dividend reinvestment can also trigger a wash sale.

A disallowed loss is not permanently lost; it is generally added to the cost basis of the replacement shares. However, a wash sale triggered by a purchase in an IRA can permanently eliminate the loss. Careful coordination across accounts is important.

When Does Tax-Loss Harvesting Make Sense?

Harvesting is most likely to add value when:

  • You hold investments in taxable accounts, since losses in IRAs and 401(k)s cannot be harvested
  • You have realized or expect to realize capital gains, such as from selling a business, diversifying a concentrated position, or rebalancing
  • You are in a higher tax bracket, which increases the value of offsetting gains and income
  • Markets have experienced volatility, creating losses in specific positions even when the overall portfolio is up

Harvesting can be especially helpful when diversifying a concentrated stock position, since harvested losses can offset gains from selling appreciated shares. Our resource on managing concentrated stock risk discusses this in more detail.

What Are the Limitations?

Tax-loss harvesting generally defers taxes rather than eliminating them. When you sell a replacement investment at a lower cost basis, you may realize a larger gain later. The benefit comes from the time value of deferral, the potential to pay lower rates in the future, and the opportunity to offset gains you would otherwise owe tax on.

Other considerations include transaction costs, the risk that the replacement investment performs differently, and the complexity of tracking lots and wash-sale rules. Harvesting should never cause a portfolio to drift from its intended allocation for the sake of a tax benefit.

There can also be meaningful planning advantages to holding appreciated assets until death, when heirs may receive a step-up in basis, or donating them to charity. Harvesting losses can complement these strategies.

Is Tax-Loss Harvesting Only a Year-End Strategy?

Many investors think of harvesting in December, but opportunities can arise any time markets decline. Monitoring portfolios throughout the year can capture losses that might disappear before year-end. Newport’s article on market uncertainty discusses how periods of volatility can create planning opportunities.

The Takeaway

Tax-loss harvesting can improve after-tax returns when used thoughtfully in taxable accounts and coordinated with your overall plan. Following the wash-sale rule, maintaining your intended allocation, and working with your CPA are essential. Newport’s private wealth team partners with clients’ CPAs and other professional advisors as part of its estate and tax planning work.

This article is provided for educational purposes only and is not individualized investment, tax, or legal advice. Please consult qualified professionals about your specific circumstances and review our disclosures.