Tax-Loss Harvesting: How to Turn Investment Losses Into Tax Savings

taxes 2026-02-27 · 5 min read tax loss harvesting capital gains tax investing taxes tax strategy taxable brokerage

Losing money on an investment stings. Tax-loss harvesting converts that sting into a tax benefit — turning paper losses into real tax savings that can be reinvested. It's one of the few tax strategies available to ordinary investors that genuinely moves the needle.

Here's how it works, when to use it, and what to watch out for.

The Basic Concept

When you sell an investment at a loss, the IRS lets you use that loss to offset capital gains. If your losses exceed your gains, you can use up to $3,000 of the excess to offset ordinary income (like wages) per year. Any remaining losses carry forward indefinitely to future tax years.

Simple example:

You have $8,000 in capital gains from selling winning stocks
You also have a $5,000 paper loss in another stock
You sell the losing stock, realizing the $5,000 loss
Your net taxable gain: $8,000 - $5,000 = $3,000
You've reduced your taxable gain by $5,000 — potentially saving $750–$1,850 depending on your tax bracket

The key insight: the tax savings are real even though you've simply rearranged your portfolio. The investment loss was going to happen whether you harvested it or not. The harvest turns it into something useful.

The Wash Sale Rule: The Critical Limitation

The IRS anticipated this strategy and created the wash sale rule to prevent abuse.

The wash sale rule: If you sell a security at a loss and buy a "substantially identical" security within 30 days before or after the sale (61-day window total), the IRS disallows the loss deduction. The disallowed loss doesn't disappear — it gets added to the cost basis of the new investment — but you lose the timing benefit of claiming it now.

What counts as "substantially identical":

The same stock (obviously)
The same mutual fund or ETF
Options on the same security

What does NOT count as substantially identical (safe to buy):

A different ETF tracking a similar but distinct index (selling Vanguard's S&P 500 ETF and buying Fidelity's S&P 500 ETF — these track the same index, which creates some gray area, but different ETFs from different providers tracking different-but-correlated indexes are clearly safe)
A stock in the same industry as the one you sold
An ETF in the same sector as the individual stock you sold

Safe replacement strategies:

Sell Vanguard Total Market (VTI) and buy Schwab Total Market (SCHB) — nearly identical exposure, clearly not the same fund
Sell an S&P 500 ETF and buy a total market ETF — different indexes, very similar exposure
Sell an individual stock and buy an ETF in that sector

Wait out the 30-day window and you can buy back the original investment if you prefer it.

When Tax-Loss Harvesting Makes Sense

It makes sense when:

You have a taxable brokerage account (it doesn't apply to IRAs or 401ks — those are already tax-advantaged)
You have positions with unrealized losses
You have realized gains in the same year that need offsetting, OR you want to generate carryforward losses
You're in a 15%+ marginal tax bracket (at the 0% capital gains rate bracket, the benefit is minimal)

It doesn't make sense when:

Your portfolio is only in tax-advantaged accounts
The losses are trivial compared to transaction costs
You're in a very low tax bracket
Harvesting would cause you to abandon an investment you fundamentally believe in long-term

The benefit scales with tax bracket. Someone in the 37% ordinary income bracket saves significantly more per dollar harvested than someone in the 22% bracket.

Long-Term vs. Short-Term Capital Gains

Tax-loss harvesting is most valuable against short-term gains. Here's why:

Long-term capital gains (assets held 1+ year): taxed at 0%, 15%, or 20% depending on income
Short-term capital gains (assets held under 1 year): taxed as ordinary income — 22%, 24%, 32%, 35%, or 37%

The IRS netting rules: short-term losses first offset short-term gains; long-term losses first offset long-term gains. Excess losses in either category can offset the other type, and then up to $3,000 can offset ordinary income.

Strategy implication: if you have short-term gains taxed at 32%, harvesting losses against them saves far more per dollar than harvesting losses against long-term gains taxed at 15%.

Automated Tax-Loss Harvesting

Robo-advisors like Betterment and Wealthfront offer automated tax-loss harvesting as a feature. The algorithm monitors your portfolio daily and harvests losses automatically when they appear, using pre-approved replacement funds to avoid wash sales.

For investors with six-figure taxable portfolios and who don't want to manage this manually, automated TLH can be valuable. Betterment and Wealthfront charge 0.25%/year for their management fees — whether that's worth it depends on your portfolio size and willingness to do this manually.

If you use a robo-advisor with TLH across multiple accounts, be careful: a wash sale triggered in a taxable account by a similar purchase in your IRA (at a different institution) is still a wash sale violation. Coordinate across all your accounts.

Year-End Harvesting vs. Ongoing Harvesting

Year-end approach: Review your portfolio in November–December each year, identify positions with significant losses, and harvest before December 31.

Ongoing approach: Monitor throughout the year and harvest whenever positions drop meaningfully (20%+ loss is a common threshold). This captures more opportunities, especially in volatile markets.

The year-end approach is simpler. The ongoing approach tends to produce higher tax savings because market dips mid-year often recover by year-end — if you wait until December, those losses may no longer exist.

What Happens to the Replacement Investment

When you sell at a loss and buy a replacement, your cost basis in the replacement is the new purchase price. When you eventually sell the replacement:

If it appreciated, you'll owe capital gains on the full gain from the replacement's purchase price
If it also lost value and you held it long-term, you have a new harvest opportunity

This means TLH often defers taxes rather than eliminates them. You're using losses now to reduce taxes now, but the replacement investments may generate gains later. The benefit comes from the time value of money — taxes paid later are worth less in real terms than taxes paid today — and from potentially converting short-term gains (taxed at higher rates) into long-term gains (lower rates) through timing.

Practical Steps to Harvest Losses

Review your taxable brokerage account for positions with unrealized losses
Calculate the tax savings against your current gains (and ordinary income if losses exceed gains)
Identify appropriate replacement securities that avoid wash sale issues
Execute the sale and immediately purchase the replacement
Document the transaction for your tax records
Set a calendar reminder 31 days after the sale to review whether to switch back to the original investment

Tax-loss harvesting requires a taxable investment account and active management, but for investors with meaningful taxable portfolios, it's one of the few completely legal ways to reduce your annual tax bill without changing your fundamental investment strategy.