How to Use Tax-Loss Harvesting to Save Money

a close up of a typewriter with a tax heaven sign on it

If you’ve ever sold an investment for less than you paid, you probably didn’t feel great about it. But what if I told you that those losses could actually help you save money on your taxes? Enter tax-loss harvesting—a smart strategy that turns your investment setbacks into tax savings.

In this guide, we’ll break down exactly how tax-loss harvesting works, why it matters, and how you can use it to keep more of your hard-earned money in your pocket. Whether you’re a seasoned investor or just getting started, this is a tactic worth understanding.

What Is Tax-Loss Harvesting?

At its core, tax-loss harvesting is a strategy where you sell investments that are losing money (i.e., “underwater”) to offset gains from other investments. The losses you realize can be used to reduce your taxable income, which means you pay less in taxes.

Here’s a simple example:
Let’s say you sold one stock for a $10,000 gain and another for a $7,000 loss. Instead of paying taxes on the full $10,000 gain, you’d only pay taxes on the net gain of $3,000. That’s a big difference!

But it doesn’t stop there. If your losses exceed your gains, you can use up to $3,000 of those losses to offset your ordinary income (like salary or interest income). And if you still have leftover losses, you can carry them forward to future years.

a piggy bank with a dollar bill sticking out of it

Why Tax-Loss Harvesting Matters

Taxes can eat into your investment returns, especially if you’re frequently buying and selling assets. Tax-loss harvesting helps you minimize that drag and keep more of your money working for you.

Key Benefits:

Reduces your tax bill: By offsetting gains and income, you lower your taxable amount.
Improves after-tax returns: More money stays invested, which can compound over time.
Offers flexibility: You can rebalance your portfolio or adjust your holdings without triggering large tax consequences.
Works year-round: While many people think about this at year-end, tax-loss harvesting can be done anytime market conditions create opportunities.

How Tax-Loss Harvesting Works: Step by Step

Let’s walk through the process so you can see how it plays out in real life.

Step 1: Identify Losing Investments

Start by reviewing your portfolio. Look for investments that are currently worth less than what you paid for them. These are your candidates for tax-loss harvesting.

Step 2: Sell the Losing Investments

Once you’ve identified the losers, sell them. This “realizes” the loss, which you can now use for tax purposes.

Step 3: Offset Gains and Income

Use the realized losses to offset any capital gains you’ve made during the year. If your losses are greater than your gains, you can use up to $3,000 to reduce your ordinary income.

Step 4: Reinvest the Proceeds

After selling, reinvest the money in a different security that fits your investment goals. This keeps your money working for you and maintains your market exposure.

Step 5: Carry Forward Excess Losses

If you still have losses after offsetting gains and income, you can carry them forward to future years. These losses can be used to offset gains or income in the future.

Real-World Example

Let’s say you’re in the 35% tax bracket and you have the following transactions:

Sold Investment A for a $20,000 gain
Sold Investment B for a $25,000 loss

Here’s how tax-loss harvesting helps:

The $25,000 loss offsets the $20,000 gain, so you owe no taxes on the gain.
You can use $3,000 of the remaining $5,000 loss to reduce your ordinary income.
The leftover $2,000 loss can be carried forward to future years.

In this scenario, you could save up to $8,050 in taxes ($7,000 from the gain offset and $1,050 from the income offset).

Common Pitfalls to Avoid

While tax-loss harvesting can be a powerful tool, there are a few things to watch out for:

The Wash-Sale Rule

The IRS has a rule called the “wash-sale rule.” If you sell a security at a loss and buy a “substantially identical” security within 30 days before or after the sale, the loss is disallowed for tax purposes.

To avoid this, make sure you don’t repurchase the same or a very similar investment within that 30-day window. Instead, consider buying a different security that meets your investment needs.

Opportunity Cost

Selling an investment means you’re out of the market for a period of time. If the market rebounds quickly, you could miss out on potential gains. Weigh the tax savings against the opportunity cost of being out of the market.

Transaction Costs

Frequent buying and selling can lead to higher transaction costs, which can eat into your savings. Make sure the tax benefits outweigh the costs.

When Is Tax-Loss Harvesting Most Effective?

Tax-loss harvesting can be beneficial in several situations:

High-Income Years

If you’ve had a particularly profitable year, you may have realized significant capital gains. Tax-loss harvesting can help offset those gains and reduce your tax bill.

Market Downturns

During volatile or down markets, many investments may be losing value. This creates opportunities to harvest losses and reduce your tax liability.

Portfolio Rebalancing

If you’re rebalancing your portfolio, tax-loss harvesting can help you make adjustments without triggering large tax consequences.

Long-Term Planning

Even if you don’t have significant gains in a given year, you can use harvested losses to offset ordinary income or carry them forward for future use.

Tips for Successful Tax-Loss Harvesting

Here are a few tips to help you get the most out of tax-loss harvesting:

1. Monitor Your Portfolio Regularly

Keep an eye on your investments throughout the year. Don’t wait until year-end to look for opportunities.

2. Diversify Your Holdings

Having a diversified portfolio increases the chances that some investments will be losing money, giving you more opportunities to harvest losses.

3. Consider Tax-Efficient Funds

Some funds are designed to minimize taxable distributions. Using these funds can reduce the need for tax-loss harvesting.

4. Work with a Financial Advisor

A financial advisor can help you navigate the complexities of tax-loss harvesting and ensure you’re making the most of your opportunities.

5. Keep Good Records

Maintain detailed records of your transactions, including purchase and sale dates, prices, and any related expenses. This will make it easier to track your losses and gains.

Tax-Loss Harvesting and Different Account Types

It’s important to note that tax-loss harvesting is most effective in taxable accounts. In tax-advantaged accounts like IRAs or 401(k)s, you don’t pay taxes on gains or losses, so there’s no benefit to harvesting losses.

Frequently Asked Questions

Can I use tax-loss harvesting in a Roth IRA?

No. Tax-loss harvesting is only applicable to taxable accounts. In tax-advantaged accounts like Roth IRAs, you don’t pay taxes on gains or losses.

How much can I offset with tax-loss harvesting?

You can use realized losses to offset capital gains dollar for dollar. If your losses exceed your gains, you can use up to $3,000 per year to offset ordinary income. Any remaining losses can be carried forward indefinitely.

What happens if I have more losses than gains?

If your losses exceed your gains, you can use up to $3,000 to offset ordinary income. The rest can be carried forward to future years.

Can I harvest losses from mutual funds or ETFs?

Yes. You can harvest losses from any type of investment, including stocks, mutual funds, and ETFs.

Is tax-loss harvesting worth it for small investors?

Even if you’re not a high-net-worth investor, tax-loss harvesting can still provide meaningful savings, especially if you have realized gains or are in a higher tax bracket.

Final Thoughts

Tax-loss harvesting is a powerful strategy that can help you reduce your tax bill and improve your after-tax returns. By selling losing investments and using those losses to offset gains and income, you can keep more of your money working for you.

While it’s not without its complexities and potential pitfalls, with careful planning and attention to detail, tax-loss harvesting can be a valuable tool in your financial arsenal. Whether you’re navigating a volatile market, rebalancing your portfolio, or simply looking to optimize your tax situation, this strategy is worth considering.

So the next time you see a losing investment in your portfolio, don’t just write it off—turn it into a tax-saving opportunity.