What is tax-loss harvesting? How investors use losses to reduce taxes

How much your portfolio earns matters, but so does how much you keep after taxes. For investors in higher tax brackets with taxable brokerage accounts, the gap between gross and after-tax returns can be significant, and tax-loss harvesting is one of the most common tools investors use to help manage it.

To be clear: Tax-loss harvesting does not eliminate taxes and it may not result in better returns. But employed deliberately, it can reduce the tax drag on a portfolio in meaningful ways that compound over time.

What is tax-loss harvesting?

Taxable capital gains are determined by subtracting losses from gains. Tax-loss harvesting is the practice of selling an investment that has declined in value to realize a loss for tax purposes, then using that loss to offset capital gains you have realized elsewhere in your portfolio. In short, you take a loss to reduce your gains.

Say you sold a position earlier in the year and realized a $20,000 capital gain. Later in the same year, you are holding another position that is down $20,000 from what you paid for it. If you sell that losing position before year-end, the $20,000 loss offsets the $20,000 gain, bringing your net taxable gain to zero for those two positions.

Calculation: $20,000 realized gain minus $20,000 realized loss = $0 net taxable gain for those two positions. Illustrative only.

If your losses exceed your gains in a given year, the excess can offset up to $3,000 of ordinary income annually ($1,500 if married filing separately). Any amount beyond that carries forward indefinitely to future tax years.

How tax-loss harvesting works

The basic process involves four steps:

First, you identify a position in your taxable account that is currently worth less than what you paid for it.

Second, you sell that position to realize the loss.

Third, the realized loss is applied against realized gains in your portfolio, reducing your net taxable gain for the year.

Lastly, you reinvest the proceeds to maintain your desired market exposure, being careful to avoid triggering the wash-sale rule (more on this below).

One important distinction worth understanding before going further: the type of loss matters.

Short-term losses (from positions held under one year) offset short-term gains first. Short-term gains are taxed at ordinary income rates, the same rates that apply to your salary and RSU income. Long-term losses (from positions held over one year) offset long-term gains first, which are taxed at preferential rates.

After offsetting similar loss types, remaining losses cross over. If your short-term losses exceed your short-term gains, the remainder offsets long-term gains. The same applies in reverse.

3 common times investors use tax-loss harvesting

Tax-loss harvesting tends to be most relevant in a few specific situations:

1. Market downturns create the most obvious opportunities. When broad markets or individual positions decline meaningfully, losses may be available across a portfolio that can be captured and put to work against gains realized elsewhere.

2. Years with significant capital gain events are a natural fit. RSU vesting, bonuses, ESPP dispositions, and other equity-related events can all affect taxable income or capital gains in a single year.

3. Rebalancing is a third opportunity. If your portfolio has drifted from its target allocation and you need to sell positions anyway, checking whether any of those positions carry a loss can turn a routine portfolio management task into a tax-planning moment.

The same logic applies to concentrated stock positions: if a single-company holding has declined and you have been looking to reduce it anyway, harvesting the loss while diversifying can accomplish both goals at once.

It is worth noting that tax-loss harvesting only applies to taxable accounts. Inside an IRA, 401(k), or other tax-advantaged account, gains are already sheltered and there is no taxable gain to offset, so the strategy does not apply.

Regardless of why you use it, it is important to maintain a focus on after-tax returns, not just tax savings.

What to watch out for

The wash-sale rule

The most important rule to understand regarding tax-loss harvesting is the wash-sale rule, which states that if you sell a position at a loss and repurchase the same or a substantially identical security within 30 days before or after the sale, the IRS disallows the loss. The wash-sale rule exists to prevent people from selling at a loss to reduce their taxable income and then immediately repurchasing the same or substantially identical securities.

Common wash-sale triggers include rebuying the same stock too quickly after selling it, purchasing call options on the same stock, and a spouse buying the same security in a separate account during the 30-day window.

To stay invested without triggering the rule, some investors sell one fund and immediately buy a similar but not identical one. For example, selling one S&P 500 ETF and purchasing a total market ETF maintains broad market exposure while the wash-sale clock runs on the original position.

That being said, if you do trigger the wash-sale rule and find a loss disallowed, it is not gone permanently. The immediate tax benefit is deferred and added to the cost basis of the replacement shares, which will reduce your taxable gain when you eventually sell them.

Selling without a broader plan

Tax-loss harvesting should always come secondary to your larger investment strategy. When you sell a position purely because it is down without considering how it fits your broader allocation, your portfolio will begin to drift from its intended exposure.

Before harvesting a loss, be sure to consider the broader implications on your portfolio and your overall plan.

State taxes

Federal taxes get most of the attention, but state taxes apply in many cases and vary significantly. High-tax states can add a meaningful layer of liability on top of federal rates, which affects the actual value of harvested losses depending on where you live.

Tax-loss harvesting only works in taxable accounts

As noted above, the strategy only applies in taxable accounts. Harvesting losses in a tax-advantaged account provides no benefit and introduces unnecessary transaction costs.

How tax-loss harvesting fits into a broader tax strategy

Tax-loss harvesting is one tool in a larger toolkit for tax-aware investing. On its own, it can reduce taxable gains in a given year. Combined with other tax strategies, it can contribute to more tax-efficient after-tax outcomes.

Other tax strategies to consider include:

• Direct indexing, which takes the concept of tax-loss harvesting further by enabling harvesting at the individual stock level within an index strategy, something a pooled fund structure cannot do.
• Asset location, which involves holding different types of investments in accounts where they are taxed most favorably and works alongside harvesting to reduce overall tax drag. Holding tax-inefficient assets in tax-advantaged accounts and tax-efficient assets in taxable accounts is a complementary approach.
• Charitable giving through a donor-advised fund (DAF) can also complement harvesting. Contributing appreciated shares directly to a DAF can help you avoid capital gains on the appreciation while simultaneously generating a deduction.

Thoughtful rebalancing is another area where harvesting can add value. Selling a losing position to rebalance and capturing the loss at the same time costs nothing extra and can meaningfully improve the after-tax outcome of what would have happened regardless.

When tax-loss harvesting makes sense

Tax-loss harvesting can be a valuable strategy when it supports a broader tax and investment plan. The key question is not whether a loss exists, but whether realizing it improves the overall after-tax outcome given your full income picture, portfolio goals, and timeline.

For investors with complex income, equity compensation, or concentrated positions, the opportunities to harvest meaningfully tend to be larger and more frequent. For investors in lower brackets with simple portfolios, the benefit may be smaller relative to the effort and complexity involved.

The right time to evaluate the strategy is before year-end, when you still have time to act, not in April when the tax year is already closed.