Tax-Loss Harvesting

Tax-loss harvesting follows a specific process to reduce your tax bill while maintaining investment exposure:

Step 1 — Identify unrealized losses. Review your portfolio for positions trading below your cost basis. Focus on positions with meaningful losses ($500+) where the tax savings justify the effort.

Step 2 — Sell the losing position. Execute the sale to realize the capital loss. The loss now appears on your tax records for the current year. Timing matters: losses realized by December 31 count for that tax year.

Step 3 — Immediately buy a substitute. To maintain market exposure, buy a correlated but not substantially identical security. If you sold AAPL at a loss, buy QQQ or XLK (tech ETFs) instead of buying AAPL back. Wait 31 days before repurchasing the original security to avoid the wash sale rule.

Step 4 — Apply losses against gains at tax time. Short-term losses first offset short-term gains (taxed at ordinary income rates of 22-37%). Then long-term losses offset long-term gains (taxed at 15-20%). Any remaining losses offset up to $3,000 of ordinary income per year.

Step 5 — Carry forward excess losses. If your losses exceed gains + $3,000, the remainder carries forward to future tax years indefinitely. This creates a growing tax shield that can offset future gains for years.

The actual tax savings depend on your tax bracket and the type of gains being offset:

Example 1 — Offsetting short-term gains: You have $10,000 in short-term capital gains (taxed at your 32% marginal rate). You harvest $10,000 in losses. Tax savings: $10,000 x 32% = $3,200. This is the highest-value scenario because short-term gains face the steepest rates.

Example 2 — Offsetting long-term gains: You have $10,000 in long-term capital gains (taxed at 15%). You harvest $10,000 in losses. Tax savings: $10,000 x 15% = $1,500. Still valuable but less impactful than offsetting short-term gains.

Example 3 — No gains to offset: You have zero capital gains but harvest $10,000 in losses. You deduct $3,000 against ordinary income (saving $960 at 32% bracket). The remaining $7,000 carries forward. Over multiple years, you will eventually use the full $10,000 in losses.

For day traders: Active day traders generate predominantly short-term gains taxed at ordinary income rates. This makes tax-loss harvesting especially valuable — every dollar of harvested loss saves $0.22-$0.37 in taxes depending on your bracket. An active trader with $50,000 in gains who harvests $20,000 in losses saves $6,400-$7,400 in taxes.

The compounding benefit: The tax savings from harvesting can be reinvested. Over 20 years, a consistent tax-loss harvesting strategy adds an estimated 0.5-1.5% in annualized after-tax returns through the compounding of deferred taxes.

The wash sale rule (IRS Section 1091) disallows a loss if you buy a "substantially identical" security within 30 days before or after the sale. The full window is 61 days (30 days before + sale date + 30 days after).

What triggers a wash sale:

• Buying the exact same stock or ETF within 30 days
• Buying options on the same security (a call option on AAPL within 30 days of selling AAPL stock at a loss)
• Buying the same security in a different account (your IRA or spouse's account)
• Reinvesting dividends from the same security during the wash sale window

What does NOT trigger a wash sale:

• Buying a different company in the same sector (sell AAPL, buy MSFT)
• Buying a broad ETF after selling a single stock (sell AAPL, buy QQQ)
• Buying a different ETF tracking a different index (sell SPY, buy VTI)

Common mistakes:

1. Forgetting about automatic dividend reinvestment — DRIP purchases within 30 days trigger wash sales. Turn off DRIP before harvesting.
2. Ignoring IRA purchases — Buying in your IRA within 30 days of selling in your taxable account triggers the rule AND permanently disallows the loss (cannot add to IRA cost basis).
3. Selling and immediately repurchasing — Some traders try to harvest a loss and repurchase the same day. This is a wash sale. You must wait 31 calendar days.
4. Not tracking across accounts — The rule applies across all your accounts, including your spouse's accounts.