Tax-loss harvesting is the practice of intentionally selling an investment that has dropped below its purchase price to lock in a deductible loss. That loss offsets your capital gains and even a slice of your ordinary income, trimming your tax bill. Done carefully, you can capture the tax benefit while keeping your portfolio's overall exposure intact.

How the offset works

A realized capital loss first cancels out capital gains of the same type — short-term against short-term, long-term against long-term — then offsets the opposite type. If losses still remain, up to $3,000 can be deducted against ordinary income each year, with anything left over carried forward to future years. Because it can shelter ordinary income taxed at high rates, a harvested loss can be worth more than its face value. The carryforward never expires, so large losses keep helping for years.

Staying invested with a replacement

The point of harvesting is to bank the loss without stepping out of the market, so investors typically reinvest the proceeds immediately. Buying a similar but not substantially identical fund — for instance, swapping one broad index fund for another tracking a different index — keeps your allocation roughly the same. This avoids missing a rebound while the loss is captured. The replacement holding maintains your strategy during the required waiting period.

The wash-sale trap

The IRS disallows the loss if you buy the same or a substantially identical security within 30 days before or after the sale — the wash-sale rule. Violating it defers the loss rather than erasing it, but it ruins the timing you were after. This is why harvesters choose a different-enough replacement and wait 31 days before buying back the original. Careful fund selection is what separates a clean harvest from a disallowed one.

When it is worth doing

Harvesting adds the most value when you have realized gains to offset, a high ordinary-income rate, and holdings sitting below cost. It is most useful in taxable brokerage accounts; it does nothing inside tax-sheltered IRAs or 401(k)s. Remember that harvesting lowers your cost basis in the replacement, so it defers rather than eliminates tax — the benefit is the time value of paying later. For long-term investors, that deferral and the ordinary-income offset can still be substantial.

You hold a fund now worth $8,000 that you bought for $12,000, and you also realized a $4,000 long-term gain this year. Selling the fund banks a $4,000 loss that fully cancels the gain, and you immediately buy a different index fund to stay invested. Your capital gains tax on that gain drops to zero.

Key takeaways

  • Harvested losses offset capital gains first, then up to $3,000 of ordinary income per year.
  • Unused losses carry forward indefinitely to future tax years.
  • Reinvest in a similar-but-not-identical asset to stay in the market.
  • The wash-sale rule disallows the loss if you rebuy the same security within 30 days.
  • Harvesting only helps in taxable accounts, not in IRAs or 401(k)s.

Common mistakes

FAQ

Can I harvest losses every year?

Yes, and you can also carry forward unused losses, so many investors harvest opportunistically whenever holdings dip below cost.

Does harvesting eliminate the tax or just delay it?

It mainly defers tax by lowering your basis in the replacement asset, though the $3,000 ordinary-income offset and the time value of deferral are real benefits.