Nobody enjoys seeing an investment fall in value, but in a taxable brokerage account a loss can have a silver lining. Tax-loss harvesting is the practice of selling an investment that is worth less than you paid for it, using that realized loss to offset taxable gains and some ordinary income, and then reinvesting the money so your long-term strategy stays on track. Done thoughtfully, it can lower your tax bill this year and leave more of your money working for you.
How capital losses offset your taxes
When you sell an investment for less than its cost basis, you realize a capital loss. Those losses first offset capital gains of the same type, short-term against short-term and long-term against long-term, and then against the other type. If your losses are larger than your gains for the year, you can use up to $3,000 of the remaining net loss to reduce your ordinary income, or $1,500 if you are married and filing separately. Anything left over carries forward to future years with no expiration date.
A simple example
Suppose you sold a fund earlier in the year for a $6,000 long-term gain, and another holding is now down $9,000. Selling the losing position wipes out the $6,000 gain entirely and leaves $3,000 to deduct against your salary. In a 22% federal bracket, that $3,000 deduction alone saves about $660, on top of the tax you avoided on the gain. You then reinvest the proceeds in a similar but not identical investment, so your portfolio's market exposure barely changes.
Key takeaways
- Losses offset gains first, then up to $3,000 of ordinary income each year.
- Unused losses carry forward with no expiration.
- Avoid buying a substantially identical security 30 days before or after the sale.
Avoid the wash sale rule
The IRS will not let you claim a loss if you buy the same or a "substantially identical" security within 30 days before or after the sale. This 61-day window includes purchases in your IRA and, in many cases, your spouse's accounts, and automatic dividend reinvestments can trigger it too. A disallowed loss is not gone forever, because it is added to the cost basis of the new shares, but it does not help you this year. Many investors swap into a fund that tracks a different index in the same asset class to stay invested while respecting the rule.
Where harvesting does and does not apply
Tax-loss harvesting only matters in taxable accounts. Gains and losses inside a 401(k), traditional IRA or Roth IRA are not reported each year, so selling at a loss there creates no deduction. It also tends to help most for investors in higher tax brackets, for those who have realized gains from selling property, a business or concentrated stock, and for anyone rebalancing a portfolio who can choose which lots to sell.
Short-term versus long-term losses
How long you held an investment matters. Positions held one year or less produce short-term gains and losses, while those held longer produce long-term ones. Short-term gains are taxed at your ordinary income rate, which is usually higher than long-term capital gains rates, so a short-term loss that offsets a short-term gain can be especially valuable. Reviewing the holding period of each tax lot before you sell helps you harvest the losses that save the most.
Keep the long game in view
Harvesting a loss lowers the cost basis of your replacement investment, which means a larger taxable gain may show up when you eventually sell it. For many people that is still a good trade, because the tax is deferred, may be taxed at a lower long-term rate, or may never be due if the asset is held until death and receives a step-up in basis. The goal is to make the decision as part of an overall plan rather than selling just to create a deduction.
Timing and record keeping
Harvesting is not just a December activity. Market dips happen throughout the year, and checking for opportunities after any sharp decline can capture losses that disappear once prices recover. Keep clear records of purchase dates, cost basis and replacement trades, and coordinate with your tax preparer. If you would like a second set of eyes, a Wealth Strategy Path advisor can review your taxable accounts and build harvesting into your yearly tax and investment plan.
