Tax-Loss Harvesting
Definition
Tax-loss harvesting is an investment strategy that sells securities at a loss to offset capital gains taxes on profitable investments.
Explanation
Tax-loss harvesting (TLH) works by selling investments that have declined in value, realizing the loss for tax purposes, and immediately reinvesting the proceeds into a similar — but not substantially identical — investment to maintain market exposure. The realized loss offsets capital gains dollar-for-dollar, and up to $3,000 of net loss can offset ordinary income annually, with unused losses carried forward indefinitely.
Most modern robo-advisors automate TLH on taxable accounts, making it a set-and-forget tax efficiency strategy. Standard TLH harvests losses at the ETF level, while direct indexing (available on Wealthfront and some other platforms for accounts over $100,000) harvests at the individual stock level for more granular tax savings. TLH is most valuable for high-income investors in top tax brackets who have significant capital gains to offset.
The main limitation of TLH is that it defers rather than eliminates taxes — it reduces the cost basis of the replacement shares, so taxes are eventually due when those shares are sold. TLH is also less beneficial in tax-advantaged accounts like IRAs and 401(k)s, where capital gains are not taxed.
Example
You have $5,000 in realized capital gains from selling a stock. You also hold an ETF that has lost $3,000. By selling the losing ETF, you offset $3,000 of the gains. Your taxable gain drops to $2,000, saving $450 in taxes at a 15% long-term capital gains rate.
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