Tax-Loss Harvesting: How It Works, When to Use It, and Key Rules
November 29, 20257 min read
Tax-Loss Harvesting: How It Works, When to Use It, and Key Rules
A clear guide to tax-loss harvesting essentials.
Tendrill
Tax-Loss Harvesting Basics: How It Works, When to Use It, and Key Rules to Know
Tax‑loss harvesting has become one of the most widely used year‑end tax strategies for investors looking to reduce their taxable burden and improve long‑term after‑tax returns. While often discussed in professional tax planning circles, the mechanics are straightforward once you break them down—and the benefits can be meaningful for investors with taxable brokerage accounts.
This guide covers what tax‑loss harvesting is, how it works step‑by‑step, when it makes sense, how to avoid wash‑sale violations, and what major firms like Vanguard and Fidelity recommend. It also includes the 2025 IRS limits, which remain critical for planning.
What Is Tax-Loss Harvesting?
Tax‑loss harvesting is the process of selling an investment in a taxable brokerage account at a loss, then using that realized loss to offset realized capital gains or reduce taxable ordinary income. The goal is not market timing but tax efficiency—maintaining market exposure while capturing a tax benefit.
Vanguard describes it simply as selling securities at a loss to offset gains or income, potentially reducing your overall tax burden (Vanguard). Fidelity notes that losses can also be used to offset up to $3,000 of ordinary income per year, with unused losses carried forward indefinitely (Fidelity).
How Tax-Loss Harvesting Works: Step-by-Step
1. Identify Investments Trading Below Cost Basis
Review your taxable accounts for positions that show unrealized losses. Gains or losses in tax‑advantaged accounts—IRAs, 401(k)s—do not count.
2. Sell the Losing Investment
Selling converts the unrealized loss into a realized loss. This is the essential tax event.
3. Replace It With a Similar—But Not Identical—Investment
To avoid being out of the market, reinvest sale proceeds into another security with similar market exposure. More on avoiding wash‑sales below.
4. Use the Loss to Offset Gains or Income
Realized capital losses can:
Offset unlimited capital gains
Offset up to $3,000 of ordinary income in 2025
Be carried forward indefinitely if unused
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5. Maintain Documentation
Brokerages will track realized losses and gains, but it’s important to keep records for tax filing and wash‑sale compliance.
When You Should Consider Tax-Loss Harvesting
Tax‑loss harvesting is most beneficial in specific situations:
You Have Realized Capital Gains
This includes gains from:
selling stocks or ETFs
real estate investment sales
the liquidation of concentrated positions
Offsetting these gains can reduce or eliminate tax liability.
You Have Unrealized Losses in Taxable Accounts
Harvesting only applies to taxable accounts. Losses in IRAs or 401(k)s cannot be used.
You Are in a High Tax Bracket
Short‑term gains are taxed at ordinary income rates. Harvesting short‑term losses to offset them is especially valuable for high‑income earners.
You Want to Build a “Loss Bank”
Some investors accumulate capital losses to use in future years, especially ahead of expected large gains (e.g., selling a business, exercising stock options). Fidelity refers to this as building a “tax savings account” of carryforward losses.
The Wash-Sale Rule: What It Is and How to Avoid It
The wash‑sale rule prevents investors from claiming a loss if they repurchase the same or a substantially identical security within 30 days before or after the sale.
This 61‑day window applies across:
taxable accounts
IRAs and 401(k)s
your spouse’s accounts
Smart Substitutes: Using ETFs to Maintain Market Exposure
One common method is switching between highly correlated—but not identical—ETFs.
Examples:
Sell SPY → Buy QQQ
SPY tracks the S&P 500; QQQ tracks the Nasdaq‑100. Correlated, not identical.
Sell SPY → Buy TLT
TLT tracks long-term Treasuries and would not be considered a substitute for an equity ETF, making it a conservative option for avoiding a wash‑sale.
Sell a single stock → Buy a sector ETF
Selling a losing tech stock and replacing it with a broad technology ETF avoids the rule while preserving exposure.
Fidelity highlights ETF substitution as a common and effective way to avoid wash‑sale violations while staying invested (Fidelity).
2025 IRS Rules and Key Limits
Capital Loss Offset Limits
Offset unlimited capital gains
Offset up to $3,000 of ordinary income ($1,500 if married filing separately)
Carry losses forward indefinitely
Short‑Term vs. Long‑Term
Short‑term losses offset short‑term gains first
Long‑term losses offset long‑term gains first
Excess losses can cross categories
This ordering matters because short‑term gains are taxed at higher ordinary rates.
Pros and Cons of Tax-Loss Harvesting
Pros
Reduces taxes owed today
Offsets gains or ordinary income
Builds carryforward losses
Keeps you invested (if using substitutes)
Improves after‑tax returns over time
Vanguard notes that reinvesting tax savings amplifies compounding over long horizons.
Cons
Potentially higher future tax bills
Replacement investments may have a lower cost basis, increasing future gains.
Wash‑sale risks
Accidental repurchases can disallow losses.
Transaction costs (less common today)
Not beneficial for tax‑advantaged accounts
May cause unintended portfolio drift
Substitutes may not fully replicate the investment sold.
How Major Firms Approach Tax-Loss Harvesting
Vanguard’s Strategy
Vanguard emphasizes avoiding market‑timing behavior and maintaining long‑term asset allocation while using harvesting to improve tax‑efficiency. They highlight the wash‑sale rule and recommend professional guidance for more complex portfolios (Vanguard).
Fidelity’s Strategy
Fidelity provides tools to identify tax‑loss harvesting opportunities and stresses the importance of replacing securities with similar—but not identical—alternatives. Fidelity encourages investors to combine harvesting with routine rebalancing for optimal results (Fidelity).
Both firms emphasize year‑round awareness rather than last‑minute December selling.
Final Thoughts
Tax‑loss harvesting is a powerful tool for reducing taxes and improving portfolio efficiency when used correctly. While the mechanics are simple, the rules—especially the wash‑sale rule—require discipline. For many investors, the strategy is most valuable when integrated into a broader tax‑aware investing plan that spans the full year rather than just the end of it.
Used thoughtfully, tax‑loss harvesting can turn market volatility into a long‑term advantage.