When Is Tax Loss Harvesting Worth It?

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Tax-loss harvesting means selling investments that have decreased in value to offset taxes on your investment gains. It's a smart strategy that can help reduce your tax bill when you invest.

But when is tax-loss harvesting worth it? The short answer is that tax-loss harvesting is most beneficial for investors in higher tax brackets with taxable investment accounts and a diverse portfolio of investments. But, of course, there are nuances to consider.

Here's everything you need to know to create a solid tax-loss harvesting strategy and reduce your tax burden.

What Is Tax-Loss Harvesting?

Tax-loss harvesting is selling investments that have gone down in value to offset taxes on investments that have gone up in value. In simple language, you're using your investment losses to reduce the taxes you owe on your investment gains.

For example, if you bought shares of a company for $10,000, and they're now worth $8,000, you could sell them and create a $2,000 loss. This loss can then be used to offset taxes on other investments that made money.

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How Tax-Loss Harvesting Reduces Your Tax Bill

When you sell investments for a profit, you pay taxes on those gains. These are called capital gains taxes. By selling investments that have lost value, you create capital losses that can directly reduce these taxes in three ways:

You can use losses to cancel out gains from other investments you sold that year.
If you have more losses than gains, you can apply up to $3,000 of those extra losses against your regular income, like your salary or business profits.
Any remaining losses can be carried forward to future tax years.

This strategy allows you to lower your tax bill while keeping your overall investment strategy intact by reinvesting in similar (but not identical) assets.

When Is Tax-Loss Harvesting Worth It

Tax-loss harvesting can often lower your tax liability, but it's not right for everyone or every situation. Whether this strategy makes sense depends on your specific financial circumstances and long-term goals.

Generally speaking, tax-loss harvesting is worth it when:

You're in a high tax bracket (32% or above)
You have significant short-term capital gains to offset
Market volatility has created temporary losses in quality investments
You need to offset required capital gain distributions from mutual funds
You're approaching retirement and need to reposition your portfolio

Let's take a closer look at these scenarios.

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5 Situations Where Tax-Loss Harvesting Works Best

1. When You're in a High-Tax Bracket

Tax-loss harvesting provides the biggest benefits to investors in higher tax brackets. If you're in the 32%, 35%, or 37% federal income tax bracket, your tax savings from harvesting losses will be much larger than for someone in the 10% or 12% bracket.

For example, if you harvest $10,000 in losses to offset short-term capital gains, someone in the 37% bracket would save $3,700 in taxes, while someone in the 12% bracket would only save $1,200.

The higher your tax rate, the more valuable each dollar of tax loss becomes.

Additionally, high-income earners may face the 3.8% Net Investment Income Tax on top of regular capital gains taxes, making tax-loss harvesting even more valuable.

2. When You Have Significant Short-Term Capital Gains to Offset

Tax-loss harvesting can serve you well when you need to offset short-term capital gains (profits from investments held less than a year). This is because short-term gains are taxed at your ordinary income tax rate, which can be as high as 37% for federal taxes plus state taxes.

In contrast, long-term capital gains (from investments held for more than a year) are taxed at preferential rates of 0%, 15%, or 20%, depending on your income. So, offsetting a short-term gain with a harvested loss can save you more in taxes than offsetting a long-term gain.

For example, if you have $15,000 in short-term gains and you're in the 35% tax bracket, your tax bill would be $5,250. If you can harvest $15,000 in losses to offset capital gains completely, you save the entire $5,250.

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3. When Market Volatility Creates Temporary Losses in Quality Investments

Market downturns and volatility often create strong tax-loss harvesting opportunities.

When the overall market drops, even quality investments with strong long-term prospects can temporarily decline in value. In these situations, you can capture tax losses and still maintain exposure to investments you believe in for the long term.

You can sell the investment to realize the loss, then purchase a similar (but not "substantially identical") investment to maintain your market exposure.

For example, if your technology ETF drops 15% during a market correction, you could sell it to capture the loss, then immediately buy a different technology ETF with similar characteristics.

4. When You Need to Offset Required Capital Gain Distributions from Mutual Funds

Even if you never sell a single share, mutual fund investors can face surprise tax bills through mandatory capital gain distributions. These payouts happen when fund managers sell holdings within the fund at a profit, and the tax burden gets passed to you.

These distributions are taxable, regardless of whether you receive them in cash or reinvest them.

Tax-loss harvesting can help offset these mandatory distributions and reduce (or even eliminate) the tax impact. This can be useful in years when mutual funds make large capital gain distributions (typically strong market years).

5. When You're Approaching Retirement and Need to Reposition Your Portfolio

As you near retirement, you may need to shift your investment mix from growth-oriented to income-producing investments. This can often involve selling appreciated assets, which can trigger capital gains taxes.

You can use tax-loss harvesting to offset gains from repositioning your portfolio - harvest losses from underperforming investments and reduce the tax impact of selling winners.

This way, you can make necessary changes to your investment approach without facing a large tax bill that could eat into your retirement savings.

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When Tax Loss Harvesting May Not Be Worth It

Tax-loss harvesting isn't always right for everyone, so here are a few scenarios where it may not be worth the effort:

When You're in a Low Tax Bracket: If you're in the 10% or 12% federal income tax bracket, your long-term capital gains tax rate is already 0%. In this case, harvesting losses come with limited benefits.
When Transaction Costs Eat the Benefits: For small investment amounts, trading commissions and bid-ask spreads can reduce or eliminate your tax savings.
In Retirement Accounts: tax-loss harvesting only works in taxable accounts. IRAs, 401(k)s, and other tax-advantaged accounts don't benefit from this strategy since gains and losses aren't taxed or deductible while investments remain in the account.
You Make Long-Term Investments with Minimal Trading: If you rarely sell investments, you'll naturally have few capital gains to offset.
When You're Close to the End of the Year: If you haven't had enough time to plan and strategize (ideally, with a tax professional), you can make mistakes or miss opportunities because you're rushing through your tax strategy.

For the best tax benefits, start your planning in advance and work with qualified financial advisors to figure out if tax-loss harvesting is worth it for you.

How To Know If Tax Loss Harvesting Is Right for You

The best thing to do is to work with a tax professional.

That said, you can also examine your tax bracket, investment accounts, and current capital gains. If you're in a tax bracket of 32% or higher, have taxable investment accounts with unrealized losses, and either have capital gains to offset or expect them shortly, tax loss harvesting could be worth it.

FAQs

How Much Tax-Loss Harvesting Can I Use in a Year?

The IRS allows you to use unlimited capital losses to offset your capital gains. If your losses are bigger than your gains, you can apply up to $3,000 of excess losses (or $1,500 for married couples filing separately) against your regular income. If you still have unused losses after applying this $3,000 limit, you can carry them forward to future tax years and continue using them to offset future gains or income.

Can Tax Loss Harvesting Be Used with All Types of Investments?

Tax-loss harvesting works with most investments in taxable accounts, including stocks, bonds, mutual funds, and ETFs. It doesn't work with investments in tax-advantaged accounts like 401(k)s or IRAs. It also doesn't apply to certain assets like your primary residence and collectibles.

Is Tax Loss Harvesting Worth It If I’m in a High Tax Bracket?

Yes, tax-loss harvesting is usually especially worth it if you're in a high tax bracket. The higher your tax rate, the more tax you save per dollar of loss harvested. For people in the lower tax brackets, savings are lower, too. Harvesting a $10,000 loss would provide much greater tax relief to someone in the 37% tax bracket than someone in the 12% bracket.

What Should I Consider Before Engaging in Tax Loss Harvesting?

Tax-loss harvesting doesn't exist in a vacuum, so you should look at your overall investment strategy, transaction costs, wash sale rules, and long-term tax implications. Your replacement investments should maintain your desired market exposure without triggering wash sales. Also, you should be aware of the fact that harvesting losses means deferring taxes, not eliminating them completely. Your new investments will have a lower cost basis, which can create larger gains in the future.

The Bottom Line

Tax-loss harvesting can reduce your current tax bill, and it works best for higher-income investors with taxable accounts who face significant capital gains taxes.

It isn't a complicated strategy in concept, but it's essential to execute it right, paying attention to factors like the timing and wash sale rules. For best results, make sure to work with a knowledgeable tax professional.