Understanding Tax-Loss Harvesting: A Practical Guide for Tax Savings and Year-End Planning

Tax-loss harvesting is a year-end tax strategy that can help reduce capital gains taxes and improve overall tax efficiency. While the concept may sound technical, the core idea is simple. By realizing capital losses in a taxable investment account, taxpayers may be able to offset realized gains and lower their tax liability. Even though this involves selling investments at a loss, the tax benefits can be meaningful when the strategy is used appropriately.

This article explains what tax-loss harvesting is, why people consider it, and how it works. It is intended for educational purposes only and does not constitute investment advice.

What Is Tax-Loss Harvesting?

Tax-loss harvesting is the practice of selling investments that have decreased in value in order to realize a capital loss. These losses can be used to offset capital gains realized elsewhere during the year. If capital losses exceed capital gains, up to $3,000 of net losses can be deducted against ordinary income each year ($1,500 if married filing separately). Any remaining unused losses carry forward to future years without expiration.

The goal is not to time the market or alter a long-term investment plan. Instead, the strategy focuses on improving the tax efficiency of an existing portfolio.

Why Taxpayers Use Tax-Loss Harvesting

1. Reduce Capital Gains Tax

Gains realized from selling appreciated securities, portfolio rebalancing, or mutual fund distributions can increase a taxpayer’s liability. Realized losses offset these gains dollar for dollar.

2. Lower Ordinary Income When Losses Exceed Gains

After capital gains have been fully offset, up to $3,000 of net losses can be deducted each year against ordinary income. Additional losses continue forward to future tax years.

3. Improve Long-Term Tax Efficiency

Reducing taxes along the way helps minimize tax drag and may enhance overall after-tax results, even though the underlying investment experienced a decline.

4. Maintain Portfolio Exposure While Realizing Losses

Taxpayers often sell the loss-position investment and replace it with a similar alternative that maintains the intended market exposure. This helps preserve the long-term investment strategy while remaining compliant with wash sale rules.

How Tax-Loss Harvesting Works

1. Identify Investments Below Their Cost Basis

When an investment’s market value is lower than its purchase price, it may present a harvesting opportunity.

2. Sell the Investment to Capture the Loss

Selling the position creates a realized capital loss for tax purposes.

3. Reinvest Thoughtfully to Avoid a Wash Sale

The IRS wash sale rule disallows the loss if the same or a “substantially identical” security is purchased within 30 days before or after the sale. Taxpayers typically replace the position with a similar fund or investment that does not violate this rule.

4. Apply the Loss on the Tax Return

Realized losses first offset capital gains. Any remaining unused loss may be applied to ordinary income and carried forward.

When Tax-Loss Harvesting May Be Most Useful

• When significant capital gains were realized during the year

• After a market decline that has created unrealized losses

• When rebalancing a portfolio and attempting to minimize taxes

• For taxpayers in higher capital gains brackets who want to improve year-end tax efficiency

Important Considerations

• Tax-loss harvesting affects the timing of taxes, not the overall economic performance of the investment.

• Wash sale rules must be followed carefully to ensure the loss is allowed.

• Not all losses are beneficial to harvest. The decision should align with long-term goals.

• Taxes are a factor in planning but should not drive investment decisions on their own.

Final Thoughts

Tax-loss harvesting can be a valuable tax-planning tool when used strategically. It provides a way to reduce capital gains taxes, lower taxable income, and create long-term tax efficiency, all without fundamentally changing a long-term investment plan.

This information is provided for general educational purposes only and is not investment advice. Any investment-related decisions should be made in consultation with a financial professional who understands your goals and risk tolerance.

If you would like assistance evaluating tax-loss harvesting from a tax perspective, our office is ready to help.