Tax-Loss Harvesting: What It Is and How It Works

Tax-loss harvesting is an investment strategy in which you deliberately sell securities that have declined in value to realize a capital loss, then use that loss to offset capital gains elsewhere in your portfolio — or to reduce ordinary income by up to $3,000 per year. The goal is not to lose money, but to convert paper losses into immediate tax savings while staying invested in the market.

Done consistently, tax-loss harvesting can add meaningful after-tax returns over a full market cycle — particularly for high-income investors in the 32–37% federal bracket who also face the 3.8% Net Investment Income Tax.

How It Works: A Simple Example

Suppose you hold Fund A, which you bought for $50,000 and is now worth $40,000 — a $10,000 loss. You also hold Fund B, which has appreciated and you plan to sell for a $15,000 gain.

Without harvesting: you sell Fund B and owe capital gains tax on $15,000.

With harvesting: you sell both Fund A and Fund B. The $10,000 loss from Fund A offsets $10,000 of the $15,000 gain from Fund B. You owe tax only on the net $5,000 gain — a $10,000 reduction in taxable gains.

Immediately after selling Fund A, you purchase a similar (but not identical) fund to maintain your market exposure. Your portfolio position stays roughly the same; you have simply realized the tax benefit.

Capital Gains Tax Rates

Short-term capital gains (assets held one year or less) are taxed at ordinary income rates — up to 37% federally. Long-term capital gains (held more than one year) are taxed at preferential rates: 0%, 15%, or 20% depending on income, plus the 3.8% NIIT for high earners.

Tax-loss harvesting is most valuable for: short-term gains (saves up to 37%), high-income investors facing the 20% + 3.8% NIIT combination on long-term gains, and investors who regularly rebalance and generate gains in the process.

The $3,000 Ordinary Income Deduction

If your total capital losses exceed your total capital gains in a given year, up to $3,000 of the net loss can be deducted against ordinary income. Any amount over $3,000 carries forward to future years indefinitely and can be used against future gains or future ordinary income.

For a high earner in the 37% bracket, a $3,000 ordinary income deduction is worth $1,110 in federal taxes — not transformative on its own, but meaningful when applied year after year.

The Wash-Sale Rule

The IRS's wash-sale rule prevents you from claiming a loss if you buy the same or a "substantially identical" security within 30 days before or after the sale. The 61-day window spans 30 days before the sale, the day of the sale, and 30 days after.

In practice: if you sell the Vanguard S&P 500 Index Fund at a loss and immediately buy the identical fund in a different account, the loss is disallowed. But if you buy the Fidelity 500 Index Fund (which tracks the same index but is not considered identical), most tax professionals consider the loss valid.

The wash-sale rule applies across all taxable accounts, including your spouse's — but not to tax-advantaged accounts (IRA, 401k). Selling in a taxable account and buying back in an IRA does not disallow the loss, but it does mean the benefit of future growth is in the tax-advantaged account.

Tax-Loss Harvesting vs. Tax-Loss Selling

A critical distinction: tax-loss harvesting involves immediately reinvesting the sale proceeds into a similar position to stay invested. Tax-loss selling — simply liquidating losing positions without reinvesting — is a different strategy with different implications for your long-term returns.

The goal of harvesting is to capture the tax benefit without changing your investment exposure. You sell Tech ETF A at a loss and immediately buy Tech ETF B with the proceeds. You are still in the market, still in tech, but now you have a realized loss you can use.

Who Benefits Most

Tax-loss harvesting is most valuable for: investors with high taxable incomes (32%+ bracket), investors who have significant realized gains in the same year from other sources (a business sale, real estate sale, RSU vesting), and investors who hold diversified portfolios with individual positions that can move independently.

It is less valuable for: investors in low income years (0% capital gains rate), those investing primarily in tax-advantaged accounts (where there is nothing to harvest), and investors close to the step-up in basis at death (if an appreciated asset is held until death, the capital gain disappears entirely).