Market volatility can be unnerving, but it also creates opportunities for long-term investors to take proactive steps toward improving after-tax returns. One of the most effective strategies during periods of market fluctuation is tax loss harvesting—a disciplined, rules-based approach that helps reduce tax liability while keeping an investment plan on track.
What Is Tax Loss Harvesting?
Tax loss harvesting involves selling investments that have declined in value to realize a capital loss. These losses can be used to offset capital gains from other investments, and if losses exceed gains, up to $3,000 can be deducted against ordinary income each year. Any unused losses can be carried forward to future tax years, providing ongoing tax efficiency. It is important to retain documentation related to the losses for tax purposes.
Why It Matters
The benefit of tax loss harvesting isn’t simply about reducing taxes today—it’s about compounding tax savings over time. By realizing losses and reinvesting in similar securities, investors can stay fully invested while capturing tax benefits that enhance long-term net returns. In volatile markets, this strategy becomes especially powerful, as short-term price dislocations can turn into long-term value.
Maintaining Portfolio Integrity
A critical element of effective tax loss harvesting is maintaining investment discipline. The goal isn’t to time the market or shift away from a long-term strategy. Instead, harvested securities are typically replaced with alternative investments that offer similar exposure without violating IRS rules. For instance, an S&P 500 ETF might be sold at a loss and replaced with a different large-cap U.S. equity ETF to preserve asset allocation while realizing the tax benefit.
Watch Out for the Wash-Sale Rule
The wash-sale rule is one of the most important considerations when implementing a tax loss harvesting strategy. Under this IRS rule, a loss is disallowed if the same or a “substantially identical” security is repurchased within 30 days before or after the sale. This includes transactions in all accounts—taxable, IRA, or even a spouse’s account.
To navigate this, it’s essential to use replacement securities that are similar, but not identical. This ensures compliance while preserving the intended investment exposure.
Things to Consider
While tax loss harvesting can be a valuable tool, it’s not always the right move in every situation. Consider the following:
- Taxable accounts only: Losses in tax-deferred accounts like IRAs or 401(k)s don’t generate tax benefits.
- Cost basis tracking: Frequent trading can complicate tax reporting and record-keeping.
- Market timing risk: While staying invested is the goal, short-term market movements can impact the effectiveness of the strategy if not carefully executed.
- Long-term strategy alignment: The replacement investment should still reflect the investor’s risk profile, time horizon, and broader goals.
A Long-Term Lens
Tax loss harvesting is most effective when applied consistently, with discipline and attention to detail. It’s not about reacting to every market dip, but about recognizing when losses can be harvested without compromising a sound investment plan.
With thoughtful implementation, tax loss harvesting can be a powerful lever for building tax-efficient wealth over time.
