Maximize your tax savings with tax-loss harvesting

Tax-loss harvesting is when you sell investments at a loss and use those losses to offset gains in other investments. You then take the money from the sale and use it to buy an investment that fills a similar role in your portfolio, so you stay invested in the market. This last point is critical—it's what distinguishes this powerful tax strategy from trying to time the market or locking in losses, and it provides the potential for increasing after-tax returns.

When you tax-loss harvest, you'll pay taxes on your realized capital gains  for the year, meaning you'll only consider your net gains—the amount you gained minus any investment losses you realized. So, if you know you're going to have some realized gains, you may want to see whether you have any opportunities to realize losses to offset them. For example, if you need to rebalance your accounts, you could sell shares of funds or stocks that have lost value since you purchased them.

Tax-loss harvesting helps you turn investment losses into an opportunity by offsetting gains and reducing your tax bill. But this strategy offers multiple benefits—outlined below—that can strengthen your long-term financial position.

When you file your income taxes, you can use tax-loss harvesting to reduce the amount you would have owed on capital gains and income. If you don't have realized gains in the same tax year, you can carry forward realized losses to offset income or gains in future tax years.¹

If you reinvest your tax savings, they'll have the opportunity to compound over the life of the investment, greatly increasing the financial benefit.

If you have assets you want to sell because of high costs or risks, tax-loss harvesting gives you a way to do so while potentially lowering a large tax bill.

Markets can't be controlled—but you can strategically control things like costs and taxes.

Learning how to harvest tax losses is key for helping put your money to work. If you have realized capital gains, you can offset them by selling securities from one of your taxable accounts at a loss and reinvesting the money in a similar investment or rebalancing, if needed. When reinvesting the funds, it's important to be aware of the IRS wash-sale rule. This rule states that if you buy the same investment or any investment the IRS considers "substantially identical" within 30 days before or after you sold at a loss, you won't be able to claim the loss.

At tax time, you have the option to reinvest your tax savings to put more of your money—and the power of compounding—to work for you.

A year when your realized losses outweigh your gains is never fun, but by using tax-loss harvesting, you can recoup some of those losses when you file. You can use up to $3,000 in net losses to offset your ordinary income (including income from dividends or interest).

Note that you can also "carry forward" losses to future tax years.

Say you sell Investment A at a $30,000 loss but realize a $25,000 gain from Investment B in the same year. Your $30,000 loss first wipes out the entire $25,000 gain—eliminating capital gains taxes on it. That leaves you with $5,000 in unused losses.

You can apply up to $3,000 of that remaining loss against your ordinary income in the same year, reducing your ordinary income taxes. The final $2,000 carries forward to offset gains or income in future years.

In this example, your total tax savings would be approximately $4,800—$3,750 from avoiding capital gains taxes on the $25,000 gain (at 15%) plus $1,050 from reducing your ordinary income taxes (at 35%).²

This hypothetical example doesn't represent any particular investment and the estimated tax savings aren't guaranteed.

As you plan for and complete your taxes, be sure to review tax resources like tax information for Vanguard funds. If you plan to tax-loss harvest, it's important to be familiar with tax basics. Key examples of these include the wash-sale rule, offsetting capital gains with losses, any rules specific to your state, and the deadline to process transactions.

IRS rules prohibit you from claiming a loss if you sell an investment at a loss then immediately repurchase it (known as a "wash sale").

If you buy the same investment or any "substantially identical" investment within 30 days before or after selling it at a loss, the loss will be disallowed. The IRS wash-sale rule applies not only to purchases of substantially identical securities within the same account, but also to purchases of substantially identical securities acquired in other accounts owned or controlled by you or your spouse or partner, including tax-deferred accounts such as IRAs and 401(k) plans. Contact a tax advisor for guidance on tax-loss harvesting, including whether an investment is considered substantially identical.

You can use realized capital losses to offset an unlimited amount of capital gains in a given year. For example, if you have $20,000 in capital gains and $20,000 in capital losses, you can offset the entire gain.

If your capital losses exceed your capital gains, you can apply up to $3,000 of the losses to offset ordinary income ($1,500 if you're married filing separately). You can also carry forward any remaining losses indefinitely to help offset gains or up to $3,000 of income in future tax years.³

Since each state has its own tax laws and regulations, state-specific rules pertaining to tax-loss harvesting can vary. For example, if a state doesn't permit loss carryforwards, tax-loss harvesting could be less beneficial. Be sure to check the rules for your state and contact a tax professional with questions.

All transactions for tax-loss harvesting must be executed and settled by the end of the calendar year. The deadline for tax-loss harvesting is usually December 31. However, if that day falls on a weekend, it might be the preceding business day. Note that transaction settlement times can vary, so it's a good idea to complete all trades well in advance of the deadline to ensure they settle in time to be included.

Cost basis calculations are important for determining the tax implications of investment transactions. An asset's cost basis is its original value for tax purposes, adjusted for stock splits, dividends, and gains. There are various cost basis methods you can use to redeem your investments based on your investing style and tax situation. The specific identification cost basis method chooses specific lots of shares to sell. While it'll take more work on your part, using this method could help you reap the greatest tax benefits.

Vanguard Brokerage Services® offers the MinTax cost basis method to its clients. This cost basis method suggests which shares to sell in order to help deliver tax-savings. You can use MinTax when processing transactions to help minimize the tax impact in most (but not all) cases. Your tax impact depends on the transaction, your tax bracket, and other factors. We recommend you contact a tax or financial advisor to see if MinTax is right for you.⁴

When selling your shares, remember to consider the holding period. If you owned your investment for more than one year, you're subject to a long-term capital gains tax rate, which is typically lower than the ordinary income tax rate. If you owned the investment for less than a year, you're subject to a short-term capital gains rate that's taxed at your ordinary income tax rate, which is often higher than 15%. Long-term gains can only be offset by long-term losses, and short-term gains can only be offset by short-term losses.

Tax-loss harvesting can be a valuable strategy for many investors, but its worth depends on your financial situation and goals. It might be worthwhile if you're in a high tax bracket or have significant realized capital gains since it can offset those and reduce your tax liability. If you're in a lower tax bracket or don't have significant capital gains, then tax-loss harvesting might not be worth it since the benefits might be limited. Contact a tax or financial advisor to see if it might be right for your situation.

When it comes to tax-loss harvesting, automation doesn't just make the job easier—it can help increase the potential benefit. That's why Vanguard's advice services offer automated tax-loss harvesting. To claim losses, the IRS requires you to comply with a number of rules—something an automated service like Vanguard's builds into the technology. An automated tax-loss harvesting service never has to take a day off, and it can easily check for opportunities across dozens of investments and hundreds of investment lots.