Tax-Loss Harvesting Explained: How to Use Losses to Lower Your Tax Bill

Tax-loss harvesting is one of the few tax strategies that generates real savings without changing your investment outcome. The concept: sell an investment that is down in value, capture the paper loss as a tax deduction, and buy a similar investment to maintain your market position. By implementing tax loss harvesting strategically throughout the year, you can reduce your taxable income while maintaining your desired asset allocation.

Quick answer

Tax-loss harvesting means selling an investment worth less than you paid, using that loss to offset capital gains elsewhere in your portfolio, and immediately buying a similar, not identical, investment so your market exposure barely changes. The loss reduces your tax bill dollar for dollar against gains, and up to $3,000 of any excess can offset ordinary income each year, with the rest carrying forward indefinitely. It only works in a taxable brokerage account, not an IRA or 401(k), and as of the 2026 tax year it still defers tax rather than erasing it, since the replacement investment starts with a lower cost basis. It's worth doing when you have real gains to offset; a $500 loss saving $75 rarely justifies the trade. Run your own numbers in the SwitchWize Money Map before deciding whether harvesting this year's losses is worth it.

The Basic Mechanics

Step 1: Identify investments in your taxable account that are worth less than you paid (unrealized losses).

Step 2: Sell them, realizing the loss.

Step 3: Use the loss to offset capital gains realized elsewhere in your portfolio.

Step 4: Buy a similar, but not "substantially identical," investment to stay invested.

Example:

• You own 100 shares of Vanguard S&P 500 ETF (VOO) purchased at $400/share ($40,000 basis)
• Current price: $340/share, portfolio value $34,000, unrealized loss: $6,000
• You sell all shares, realizing a $6,000 capital loss
• You immediately buy iShares S&P 500 ETF (IVV) for $34,000, tracking the same index
• The $6,000 loss offsets $6,000 of capital gains elsewhere
• Your portfolio is effectively unchanged, still 100% S&P 500 exposure

The math behind that savings is simple: loss realized × marginal capital-gains rate = tax saved. At a 15% capital-gains rate, $6,000 × 0.15 = $900 saved. At a 20% rate (the top bracket), the same $6,000 loss saves $1,200.

How Losses Offset Gains

Capital losses offset capital gains dollar-for-dollar. The netting rules:

1. Short-term losses offset short-term gains first
2. Long-term losses offset long-term gains first
3. Excess short-term losses can offset long-term gains (and vice versa)
4. If total losses exceed total gains, up to $3,000 of net losses can offset ordinary income per year
5. Losses beyond $3,000 carry forward indefinitely to future tax years

The $3,000 ordinary income offset is available every year, meaning ongoing loss carryforwards continue providing benefit until exhausted.

The Wash-Sale Rule

The IRS disallows a loss if you buy the same or "substantially identical" security within 30 days before or after the sale (a 61-day window total). This is the critical rule to understand.

If the wash-sale rule is triggered, the disallowed loss is added to the basis of the replacement security; it is not permanently lost, just deferred.

If the proceeds from the sale sit in your brokerage's cash sweep for a day or two while you pick the replacement, check what that cash is actually earning. A linked high-yield savings account can pay 4.20% right now, while some legacy sweep accounts still pay close to nothing on the same balance.

When It Is Worth Doing

It is less valuable when:

• You have no capital gains to offset and are already using the $3,000 ordinary income deduction
• Your investments are inside tax-advantaged accounts
• Transaction costs and effort exceed the tax benefit

Read more on how gains are taxed in the first place in capital gains tax explained, how the netting rules interact with your overall bracket in tax brackets explained, and check the tax-loss harvesting calculator to estimate your specific savings before you place a trade.

Sources

The wash-sale rule and loss-netting order described above follow IRS Publication 550, Investment Income and Expenses (irs.gov/publications/p550), and IRS Topic 409, Capital Gains and Losses (irs.gov/taxtopics/tc409). Tax-loss harvesting involves complex, fact-specific tax rules; consult a tax advisor before executing, particularly around the wash-sale rule and your own cost-basis history.