Tax-loss harvesting is the practice of selling an investment at a loss to offset capital gains elsewhere in your portfolio, reducing your current-year tax bill. It is one of the few strategies that can generate real, measurable value without changing your risk exposure or long-term investment strategy.
How It Works
Suppose you own a U.S. total stock market fund that has declined $15,000 from your purchase price. You sell the fund, realizing a $15,000 capital loss. You immediately purchase a similar (but not "substantially identical") fund — such as an S&P 500 fund or a large-cap value fund — maintaining your market exposure. The $15,000 loss can offset $15,000 in capital gains from other sales, rebalancing activity, or mutual fund distributions.
If your losses exceed your gains, you can deduct up to $3,000 per year against ordinary income, with the remainder carried forward to future tax years indefinitely. At a 24% federal rate plus 4.95% Illinois state rate, a $15,000 loss offset against ordinary income saves approximately $4,343 in taxes.
When to Harvest
The best opportunities for tax-loss harvesting arise during market downturns and periods of volatility. When the market drops 10%, 20%, or more, losses are widespread across asset classes. These moments — which feel terrible emotionally — are actually valuable from a tax perspective.
We also look for harvesting opportunities during routine portfolio events: rebalancing, cash withdrawals, and new contributions. Any time we are making a trade, we evaluate whether a harvesting opportunity exists in another part of the portfolio.
The Wash Sale Rule
The IRS wash sale rule prohibits claiming a loss if you purchase a "substantially identical" security within 30 days before or after the sale. This means you cannot sell a total stock market index fund and immediately repurchase the same fund. However, you can purchase a different fund with similar (but not identical) characteristics. The key is maintaining your target asset allocation while avoiding a wash sale violation.
Limitations and Considerations
Tax-loss harvesting is not free money. It reduces your cost basis in the replacement security, which means you will owe more tax when you eventually sell at a gain. The benefit is deferral — paying tax later rather than sooner — plus the possibility of realizing those deferred gains at a lower rate (e.g., during retirement or at long-term capital gains rates). For most investors, the present value of the tax deferral plus the $3,000 annual ordinary income offset makes harvesting well worth the effort.
Meridian Wealth Advisors is an SEC-registered investment advisor. This article is for educational purposes and does not constitute personalized tax or investment advice.