Tax-Loss Harvesting

The strategy of deliberately selling investments at a loss to offset capital gains or ordinary income, reducing your tax liability for the year — while replacing the sold investment with a similar one to maintain portfolio exposure.

Tax-loss harvesting is the practice of intentionally selling a security that has declined in value to realize a capital loss, which can then be used to offset capital gains from other sales (reducing the tax on those gains) or, if losses exceed gains, to offset up to $3,000 of ordinary income per year. The remaining unused losses carry forward indefinitely to future tax years. The key insight is that the loss provides a tax benefit today while the underlying investment position is immediately replaced with a similar (but not substantially identical) security — maintaining your portfolio's market exposure while capturing a tax deduction.

Tax-loss harvesting is not about permanently disposing of an investment — it's about timing. You're accelerating the recognition of a loss into the current tax year, where it can offset gains or income at your current marginal rate, while deferring the taxable gain until a future year (when you eventually sell the replacement security). The future tax bill doesn't disappear; it's deferred. But time value of money makes a tax deduction today more valuable than the same deduction years from now, and if your tax rate is lower in retirement when you eventually sell, you may pay less than you would have today.

The mechanics require careful attention to the wash sale rule: you cannot sell a security at a loss and buy back a 'substantially identical' security within 30 days before or after the sale. The practical workaround is to immediately reinvest the proceeds into a similar but different security — selling an S&P 500 index fund and buying a total market fund, for example, or selling one tech ETF and buying a different one with similar but distinct holdings. This way you're continuously invested (avoiding market timing risk) while still capturing the tax loss. After 31 days, you can switch back to the original holding if you prefer.

For people with significant equity compensation — large RSU vesting events, stock option exercises, or ESPP sales — tax-loss harvesting can be a powerful tool for managing the tax impact. If you have $50,000 in capital gains from selling vested RSUs and you also hold a taxable brokerage account with positions that have declined in value, harvesting those losses directly offsets the gains dollar for dollar. Many robo-advisors (Betterment, Wealthfront) automate daily tax-loss harvesting as a core feature. Manual harvesting is also effective, particularly in volatile markets and at year-end when the full year's gains are visible.

How Tax-Loss Harvesting Works: Step by Step

  • Identify positions in your taxable account that are currently worth less than you paid for them — these have unrealized losses.
  • Calculate the tax benefit: a $10,000 loss offsets $10,000 of capital gains (at 15–20% LTCG rates, that's $1,500–$2,000 in tax savings) or $3,000 of ordinary income (at a 32% marginal rate, that's $960 in tax savings).
  • Sell the losing position to realize the loss — this creates a reportable capital loss on your tax return.
  • Immediately reinvest the proceeds into a similar but not substantially identical security to maintain your market exposure.
  • Wait at least 31 days before repurchasing the original security if you want to go back to it.
  • Report the loss on Schedule D of your tax return — your broker will generate a 1099-B with the relevant details.

Limits and Considerations

  • The $3,000 ordinary income offset cap: if your capital losses exceed your capital gains, only $3,000 can offset ordinary income per year — excess carries forward.
  • Loss carryforward: unused losses carry forward indefinitely and can be used in future years — they don't expire.
  • Short-term vs. long-term matching: short-term losses first offset short-term gains (ordinary rates), then long-term gains. Long-term losses first offset long-term gains, then short-term gains. The netting rules affect the value of the harvest.
  • Transaction costs: harvesting in accounts with trading commissions or with assets that have bid/ask spreads reduces the net benefit — most is negligible with modern commission-free brokers.
  • State taxes: some states don't allow full loss deductions or have different carryforward rules — the federal mechanics don't always translate directly at the state level.
  • Automated harvesting: robo-advisors that harvest daily can capture losses in real time as markets move, potentially generating more harvesting opportunities than end-of-year manual review.

Tax-Loss Harvesting and Equity Compensation

Employees with significant equity compensation often have large, concentrated positions in company stock — and therefore large potential capital gains exposure when they sell. Tax-loss harvesting in a diversified taxable portfolio can generate losses to offset those gains. For example, if you sell $100,000 of vested RSUs with a low cost basis (generating $80,000 in long-term capital gains) and simultaneously harvest $30,000 in losses from a declining position in your brokerage account, your net taxable capital gains drop to $50,000. At a 15% LTCG rate, that's $4,500 in tax savings. The tradeoff is that you've realized losses on positions that may recover — but the tax benefit today is real and the replacement security maintains your market exposure.

Example

In November, a product manager reviews her taxable brokerage account. She has $40,000 in long-term capital gains from selling RSUs earlier in the year. She also holds a total international stock ETF she bought two years ago that is currently down $18,000 from her cost basis. She sells the international ETF, immediately purchases a different international ETF with similar but not identical composition (avoiding a wash sale), and realizes an $18,000 loss. The loss offsets $18,000 of her $40,000 in gains, reducing her long-term capital gains tax bill by $2,700 (at 15%). She maintains her international equity exposure through the replacement ETF without interruption.