When markets ebb and flow, an informed investor can turn downturns into opportunities. Tax-loss harvesting empowers you to strategically sell underperforming securities to reduce your taxable gains—and even offset ordinary income when losses exceed gains. This approach transforms red ink from a setback into a tool for long-term growth.

With thoughtful planning and attention to IRS rules, you can harvest losses to offset capital gains and strengthen your portfolio’s after-tax performance year-round.

What is tax-loss harvesting?

Tax-loss harvesting (TLH) is a systematic process where investors sell assets that have declined below their purchase price, realizing a capital loss. These losses can then offset capital gains generated elsewhere in your taxable accounts.

Unlike 401(k) or IRA holdings, TLH applies exclusively to investments held in taxable accounts only. It does not reduce your contributions or holdings in tax-advantaged accounts, preserving their tax-deferred or tax-exempt status.

How tax-loss harvesting works

• Identify investment losses: Review your portfolio for positions trading below your original cost basis to spot candidates for sale.
• Sell losing investments: Realize a capital loss by divesting assets that no longer align with your performance targets.
• Offset gains: Apply the realized losses to offset capital gains without dollar limits on the amount of gains you can neutralize.
• Offset ordinary income: Use up to $3,000 of residual losses each year to reduce your taxable income under IRS rules.
• Carry forward unused losses: Preserve any excess losses for future years through an unlimited carryforward for unused losses.
• Reinvest prudently: Acquire a similar, but not substantially identical, security to maintain allocation and avoid wash-sale rule violations.

Example scenarios and calculations

Consider two illustrative scenarios that highlight the potential impact of TLH. In the first case, you realize a $30,000 loss on one position and have $25,000 in gains elsewhere. By offsetting the entire $25,000, you eliminate capital gains tax on that amount. You then apply $3,000 to reduce ordinary income, leaving $2,000 to carry forward to the next tax year. Assuming a 15% long-term rate and a 35% ordinary bracket, your combined tax savings could reach $4,800.

In a second scenario, an investor posts $33,000 in losses against $30,000 in gains. After zeroing out the gains and deducting $3,000 of income, they have no capital gains tax liability and still maintain a $0 net balance in that tax year, while preserving the strategic ability to use further losses later. These examples underscore how TLH can deliver meaningful annual tax savings.

Key IRS rules and regulatory considerations

The IRS wash-sale rule prevents claiming a loss if you repurchase the same or a substantially identical security within 30 days before or after the sale. Violating this rule results in disallowing the loss and adjusting the cost basis of the replacement security.

There is no cap on losses used to offset capital gains, but only $3,000 per year (or $1,500 if married filing separately) can offset ordinary income. Remaining losses roll forward indefinitely, providing long-term tax planning flexibility.

Summary of tax-loss harvesting dynamics

Best practices for implementing TLH

• Monitor portfolios year-round: Tax-loss harvesting is most effective when executed throughout the year, not just in December.
• Maintain consistent allocation: Reinvest in diversified, similar assets to preserve your risk profile.
• Personalize your approach: Tailor TLH to your unique tax bracket, investment objectives, and projected income.

Strategic use cases

• Mitigate large gains: Counteract gains from business sales, employer stock, or concentrated positions with targeted loss harvesting.
• Balance fund distributions: Offset unexpected capital gain distributions from mutual funds at year end.
• Enhance tax planning: Combine TLH with charitable contributions or qualified opportunity funds for holistic tax strategies.

Conclusion

Tax-loss harvesting is both an art and a science. By methodically identifying and realizing losses, you can transform market volatility into a source of tax efficiency. Throughout each year, disciplined implementation of TLH can generate significant savings, strengthen your after-tax returns dramatically, and reinforce your investment objectives. Embrace this strategy with awareness of wash-sale rules, IRS limits, and your personal financial goals. When executed thoughtfully, tax-loss harvesting can become a cornerstone of your portfolio’s resilience and long-term success.