Tax-Loss Harvesting: How to Reduce Your Tax Bill

Dec 22

From time to time, even the best investors out there endure some losses; but the savviest among them see the silver lining in the same and enlist the help of dedicated strategies such as tax-loss harvesting, a powerful tool for reducing your tax bill and optimizing your investment portfolio. This article explores this topic in more detail so you can learn all about it. Let’s dive in!

What is tax-loss harvesting?

Tax-loss harvesting is a strategy investors use to minimize their tax liability by selling investments that have decreased in value, an approach that can benefit your taxes in two ways—with losses used to offset investment gains and, in some cases, also reduce your personal income tax by allowing you to write off up to $3,000 in losses each year ($1,500 each for married taxpayers filing separately). Any unused losses are carried over to future tax years to offset future gains or income when needed, with no expiration date. Essentially, tax-loss harvesting gives you the means to lower your tax bill via underperforming investments.

This strategy is based on the tax code's treatment of capital gains and losses, permitting investors to use losses to counterbalance gains. In strategically timing the sale of investments that have lost value, investors can effectively minimize their tax liability while maintaining their overall investment strategy.

How tax-loss harvesting works

When you sell an investment for a profit, you incur capital gains tax based on the duration of ownership. For example, if you sell Investment A for a net profit of $10,000 but owe short-term capital gains tax (as you owned it for less than a year), your tax rate could ring in as high as 37% (as of 2025). Those who find themselves in the 35% tax bracket would be liable for $3,500 in taxes on a $10,000 profit.

Implementing a tax-loss harvesting strategy

Building on the aforementioned, consider this example of how tax-loss harvesting can significantly alter your tax obligations…

Earlier that same year, let’s assume you bought Investment B—which performed poorly, so you sell it for a loss of $15,000 that is then used to offset previous Investment A gains. In applying the $15,000 loss from Investment B against the $10,000 profit from Investment A, you would owe zero capital gains tax.

That’s not all, however, as you still have an additional $5,000 loss ($15,000 minus the offsetting $10,000 Investment A profit) to apply in two ways: you can deduct $3,000 from your taxable income, potentially saving $1,050 in taxes (based on a 35% tax rate), AND carry over the remaining $2,000 loss to future tax years.

Financial benefits of tax-loss harvesting

This tax-loss harvesting example reflects overall tax savings of $4,550, a number that includes $3,500 owed on Investment A’s profit and the $1,050 tax benefit from the additional income offset. Plus, you have $2,000 available to apply towards future gains.

Can tax-loss harvesting benefit you without capital gains?

You might wonder: What if I don’t have any capital gains to offset? Can I still benefit? The answer is a resounding YES!

For example, let’s say you bought Investment C for $8,000 and later sold it for $6,000; you can still leverage this $2,000 loss, reinvesting your $6,000 proceeds in Investment D and applying the $2,000 loss to offset your taxable income for that year. With a tax benefit of $700 (based on a 35% tax rate), you can reinvest this savings as part of a larger investment strategy.

Embracing routine tax-loss harvesting

While some tax-loss harvesting limitations (which we’ll get into shortly) do exist, utilizing this strategy on a regular basis allows you to convert underperforming assets into significant tax savings. Investors who actively rebalance their portfolios can likewise make informed decisions to maximize returns and minimize tax burdens, ensuring poor-performing investments translate into actionable tax strategies. In understanding and implementing tax-loss harvesting, you can enhance your investment strategy and optimize your tax savings to make the most of your financial opportunities.

Tax-harvesting rules to follow

Tax-loss harvesting is indeed a valuable strategy, but it does come with specific rules and complexities investors must be aware of including…

Wash-sale rule

One of the biggest tax-loss harvesting issues investors must be mindful of is the wash-sale rule, which prohibits the repurchase of a "substantially identical" security within 30 days of selling it at a loss. Violating this rule can nullify the tax benefits of the transaction, though you can still replace ETFs that track similarly (or even the same index) without doing so.

Taxable accounts only

As the primary goal of tax-loss harvesting is to offset capital gains taxes, it only applies to taxable accounts and doesn’t extend to their tax-sheltered counterparts (e.g., 529 plans, IRAs, 401(k)s, and 403(b)s).

Realizing losses before year-end

As with many tax strategies, it’s important to wrap up your tax-loss harvesting efforts by the end of the calendar year (December 31) while considering this approach as part of your overall tax strategy.

Long-term vs. short-term capital gains

Capital gains tax treatment varies based on the holding period of the investment and your income level. For assets held longer than a year, long-term capital gains are generally taxed at lower rates (0%, 15%, or 20%, depending on your income) than short-term gains—taxed at the same rate as ordinary income. Since tax-loss harvesting is primarily about offsetting capital gains taxes, it’s especially beneficial for those in higher tax brackets.

Netting gains and losses

Investors can offset capital gains with capital losses, but it's crucial to calculate the net gain or loss in an accurate manner. While this process may sound straightforward (and it often is!), complications can arise if you don’t buy all shares concurrently (e.g., if you buy Company A once a month using a dollar-cost averaging strategy, the purchase prices will fluctuate). Such variability can add complexity to net gain or loss calculations, making it essential to maintain good records and thus report the correct cost basis to the IRS.

Deductions limitations

Tax-loss harvesting can help offset losses, but limits do exist as the IRS imposes restrictions on the amount of capital losses you can deduct in a given tax year: impacting the overall effectiveness of this strategy.

Tax-loss harvesting limitations

While tax-loss harvesting is often an effective method, it’s important to recognize various limitations. These include:

Market-timing risks

Attempting to time the market to avoid losses is often quite challenging and can lead to missed opportunities for gains. Your investments should be in place because you believe in their long-term growth potential, but remember that the market fluctuates; selling an investment as soon as it dips can make it nearly impossible to achieve and maintain long-term portfolio growth. Tax-loss harvesting is therefore best utilized as part of a broader strategy (e.g., rebalancing).

Administrative burden

Tax-loss harvesting calls for careful record-keeping and investment monitoring—both time-consuming tasks—but working with a financial advisor can thankfully help streamline these processes.

Tax code changes

While Benjamin Franklin’s words “Nothing is certain but death and taxes” may well be true, this certainly doesn’t mean taxes stay the same over time. The tax code and regulations continue to evolve, with these updates primed to impact tax-loss harvesting effectiveness. Teaming up with a tax professional can help limit the corresponding risk of leaving money on the table and/or making costly errors and is thus recommended.

The takeaway: tax-loss harvesting

Tax-loss harvesting offers several benefits for investors including reduced tax liability, portfolio optimization, and enhanced returns. Making the most of this strategy, however, requires a solid understanding of various tax rules, implications, and limitations. With careful planning and guidance from a financial professional, you can count tax-loss harvesting among the most powerful tools in your financial toolkit.

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