Direct answer: Tax-loss harvesting is the practice of selling investments that are below their cost basis to realize a capital loss, which can offset capital gains elsewhere in the portfolio or reduce ordinary income by up to $3,000 per year. In down years (2022 saw the S&P 500 down 18% and U.S. bonds down 13%), broad portfolios have unrealized losses that can be harvested. The harvested loss defers future taxes without changing market exposure (if a similar fund is immediately purchased), creating a permanent tax benefit when the deferred gains eventually come due at potentially lower rates.
Scenario: Tax-Loss Harvesting in a Down Year
Key Takeaways
- In 2022, a 60/40 portfolio (60% U.S. equity, 40% U.S. aggregate bonds) fell approximately 17%. An investor who harvested losses during 2022 by selling their equity and bond funds and repurchasing similar (not substantially identical) alternatives could have harvested losses of $17,000 on a $100,000 portfolio.
- A $17,000 harvested loss can offset $17,000 of capital gains that year (eliminating the tax on those gains) or offset $3,000 of ordinary income in 2022 with $14,000 carrying forward to offset future gains.
- The wash-sale rule prohibits repurchasing the same fund or substantially identical fund within 30 days; the solution is to maintain market exposure by buying a fund tracking a different but correlated index (e.g., sell Vanguard Total Stock Market and buy Schwab Total Stock Market, which track different but highly correlated indices).
- The benefit compounds: the deferred tax is essentially an interest-free loan from the IRS; the tax liability remains but has been pushed into the future, allowing the capital to compound without being reduced by the current-year tax payment.
- Tax-loss harvesting has diminishing value for: investors in low tax brackets (0% long-term capital gains rate), assets held in tax-deferred accounts (no taxable gains to offset), and investors who expect tax rates to rise significantly (the harvested loss deferred may face a higher rate in the future).
The 2022 Scenario: Numbers
Investor profile: married filing jointly, 32% marginal ordinary income tax rate, 15% long-term capital gains rate, 3.8% NIIT applies (total 18.8% long-term capital gains rate effective). Portfolio: $500,000 taxable account, 60% in Vanguard Total Stock Market ETF (VTSAX/VTI), 40% in Vanguard Total Bond Market ETF (BND). Starting cost basis: purchased primarily in 2018 to 2019, basis approximately $450,000 (representing $50,000 in embedded long-term gains). After 2022 decline: VTI position is now at market value 18% below basis (loss), BND position is at market value 14% below basis (loss). Unrealized loss on both positions combined: approximately $80,000 (on the $480,000 remaining portfolio). Harvest strategy: sell both positions, immediately buy iShares Core S&P Total U.S. Stock Market ETF (ITOT, tracks a different index than VTI) and iShares Core U.S. Aggregate Bond ETF (AGG, different from BND).
The Tax Math
The $80,000 realized loss from the 2022 harvest can offset $80,000 of capital gains. If the investor had no realized gains elsewhere in 2022, $3,000 reduces ordinary income (saving $3,000 times 32% = $960 in taxes) and the remaining $77,000 carries forward as a net capital loss to future years. In 2023, if the recovered portfolio generates $50,000 in realized long-term gains (from other rebalancing or sales), the carryforward offsets those gains: $50,000 gain minus $50,000 carryforward = $0 taxable gain, saving the investor 18.8% times $50,000 = $9,400 in taxes. The remaining $27,000 carryforward continues until used. Total present-value tax savings: meaningful and real, with compounding benefit from investing the money that would otherwise have been paid in taxes.
Wash-Sale Rule Implementation
The wash-sale rule requires waiting 31 days before repurchasing the sold fund or a substantially identical fund. Substantially identical means: the same ETF, the same fund in a different share class (VTSAX and VTI are the same underlying fund, different formats), or a fund tracking the same index with the same provider. Not substantially identical: funds tracking different indices (VTI tracks CRSP US Total Market Index; ITOT tracks S&P Total Market Index; SCHB tracks Dow Jones U.S. Broad Stock Market Index). The risk of tax-loss harvesting via an alternative fund is tracking error: if ITOT rises while VTI falls during the 31-day wait period (extremely unlikely for funds this closely correlated), the investor participates differently. Practically, the tracking difference between VTI and ITOT over a 31-day window is negligible.
When Tax-Loss Harvesting Is Not Worth It
Tax-loss harvesting requires: realized loss (the position must be below cost basis); a meaningful tax rate on gains (investors in the 0% long-term capital gains bracket get no benefit); a taxable account (IRA and 401(k) gains are already tax-deferred); willingness to track cost basis across fund substitutions (creates administrative complexity); and an expectation that tax rates will not increase dramatically in the future (harvesting defers tax, so if future rates are higher, the benefit is reduced or reversed). For investors with simple portfolios, low tax rates, or primarily tax-deferred savings, the administrative complexity of tax-loss harvesting may not be justified by the benefit.
Frequently Asked Questions
Can I harvest losses on every position in my portfolio simultaneously?
Yes, with caveats. You can harvest losses on multiple positions simultaneously. The wash-sale rule applies per security: you must avoid repurchasing each specific sold security within 31 days. For each harvested position, you need a suitable alternative that maintains your target exposure without triggering a wash sale. For an investor with 5 different ETFs, each can be harvested and replaced with a similar alternative ETF on the same day. For investors with individual stocks, the wash-sale rule is less of a constraint because each individual stock is its own security; selling Apple stock and immediately buying Microsoft stock is not a wash sale.
Does tax-loss harvesting work for fixed income?
Yes. In 2022, the U.S. aggregate bond index fell approximately 13%. An investor holding BND (Vanguard Total Bond Market) could have sold and repurchased iShares AGG (iShares Core U.S. Aggregate Bond) or Schwab's SCHZ to maintain bond exposure while realizing the loss. The wash-sale mechanics are identical to equity harvesting. Bond fund harvesting is valuable for investors with significant taxable bond holdings; the harvested loss offsets other capital gains at the investor's full capital gains rate (short-term gains for bonds held less than a year, long-term for those held longer).
How does tax-loss harvesting interact with a portfolio rebalance?
A market decline that produces harvestable losses often also shifts the portfolio's asset allocation (equities fall more than bonds in a stock market decline, reducing the equity percentage). A combined harvest-and-rebalance is often optimal: sell the equity fund that is below basis (harvesting the loss) and use the proceeds to rebalance toward target allocation while buying the alternative equity fund. This combines two beneficial actions into one set of transactions, reducing both the tax liability and the tracking error introduced by the harvest substitution.