Tax-Loss Harvesting Step by Step

Tax-loss harvesting is the practice of selling investments at a loss to offset capital gains and reduce your tax bill. It's one of the few strategies that lets you benefit from bad performance. When done correctly, you maintain your investment exposure while generating real tax savings. It's like finding money in the couch cushions of your portfolio.

How It Works — The Concept

Imagine you bought an S&P 500 fund for $10,000 and it's now worth $8,000. You have a $2,000 unrealized loss. If you sell, that loss becomes "realized" — and you can use it to offset other gains or deduct it from your income.

But here's the key: you don't want to be out of the market. So immediately after selling, you buy a similar (but not identical) investment. You stay invested, your portfolio barely changes, but you've captured a tax benefit.

That $2,000 loss can offset $2,000 in capital gains elsewhere — saving you $300 at a 15% long-term rate, or $480 at a 24% ordinary income rate. If you have no gains to offset, you can deduct up to $3,000 of losses against ordinary income per year, and carry forward any excess indefinitely.

Step-by-Step Process

Step 1: Identify Positions at a Loss

Review your taxable brokerage account (not IRAs or 401(k)s — tax-loss harvesting only works in taxable accounts). Look for any holdings that are currently below your cost basis.

Common candidates: individual stocks that have declined, bond funds when interest rates have risen, international funds during underperformance, sector-specific ETFs.

Step 2: Sell the Losing Position

Place a market order to sell the entire position (or the specific lots that are at a loss). Your brokerage will report the realized loss on your 1099.

Step 3: Buy a Replacement Investment

Immediately — or as soon as your sell settles — buy a similar investment that maintains your portfolio's allocation and risk profile. The replacement must not be "substantially identical" to what you sold (see wash-sale rules below).

Good replacement pairs:

• Vanguard S&P 500 ETF (VOO) → iShares Core S&P 500 ETF (IVV)
• Vanguard Total Stock Market (VTI) → Schwab U.S. Broad Market (SCHB)
• iShares MSCI EAFE (EFA) → Vanguard FTSE Developed Markets (VEA)
• One bond fund → A different bond fund with similar duration

Step 4: Wait 31 Days (Wash-Sale Rule)

The IRS wash-sale rule says you cannot buy a "substantially identical" security within 30 days before or after selling at a loss. If you do, the loss is disallowed. This means:

• Don't buy back the exact same fund for 31 days
• Don't buy it in another account (IRA, spouse's account) within the window
• Do buy a similar but different fund immediately — this is perfectly legal

After 31 days, if you prefer your original holding, you can sell the replacement and buy back the original.

Step 5: Record Everything

Keep track of:

• What you sold, when, and at what price
• The realized loss amount
• What you bought as a replacement
• When the wash-sale window expires

Your brokerage handles most of this on your 1099, but maintaining your own records helps at tax time.

The Math: Why It Matters

Suppose you harvest $10,000 in losses per year for 20 years. At a 15% long-term capital gains rate, that's $1,500 per year in tax savings — $30,000 total. If you invest those tax savings and earn 9% annually, that $30,000 grows to approximately $90,000. Tax-loss harvesting literally creates wealth out of market declines.

When to Harvest

Market downturns. Broad market declines create harvesting opportunities across your entire portfolio. March 2020 was an incredible tax-loss harvesting opportunity.

Year-end. Review your portfolio in November-December for harvesting opportunities before the tax year closes.

After buying at a high point. If you made a lump-sum investment and the market drops shortly after, you may have immediate harvesting opportunities.

Continuously. The best approach is to monitor throughout the year, not just at year-end. Software like Wealthfront and Betterment automate this.

Important Rules and Limitations

Only works in taxable accounts. Gains and losses inside IRAs and 401(k)s have no tax impact.

$3,000 annual limit against ordinary income. If your losses exceed your gains, you can only deduct $3,000 against other income per year. The rest carries forward to future years — indefinitely.

Wash-sale rule applies across accounts. If you sell at a loss in your brokerage account and buy the same security in your IRA within 30 days, the loss is disallowed.

Lower cost basis on replacement. When you buy the replacement at a lower price, your new cost basis is lower. This means you'll eventually owe more in gains when you sell the replacement — you're deferring tax, not eliminating it. But deferring is valuable because of the time value of money.