Tax Loss Harvesting: Turn Losses Into Savings | FireTax

Market downturns don't have to be all bad news. Tax loss harvesting is a powerful strategy that lets you turn investment losses into immediate tax savings, all while maintaining your investment strategy. Here's how to do it right.

What Is Tax Loss Harvesting?

Tax loss harvesting involves selling investments at a loss to offset capital gains and potentially reduce your ordinary income taxes.

The benefits:

Offset capital gains dollar-for-dollar
Reduce ordinary income by up to $3,000 per year
Carry forward unlimited losses to future years
Maintain your investment strategy with similar assets
Improve after-tax returns without changing risk exposure

Tax loss harvesting only works in taxable brokerage accounts, not in IRAs or 401(k)s where investments grow tax-deferred anyway.

The Wash Sale Rule: Your Biggest Obstacle

The IRS isn't going to let you have your cake and eat it too. The wash sale rule prevents you from claiming a loss if you buy a 'substantially identical' security within 30 days before or after the sale.

Key wash sale facts:

The 30-day window applies both before AND after the sale (61 days total)
Buying the same security in your IRA can trigger wash sale
Buying it in your spouse's account can trigger wash sale
Substantially identical means same company/same fund
Similar but different funds are usually okay

How to Avoid Wash Sales

Strategy 1: Wait 31 days before buying back

Pros: Simple, guaranteed to work. Cons: Out of the market for a month (risk of missing gains).

Strategy 2: Buy a similar but not identical fund immediately

Examples of acceptable swaps:

VOO (Vanguard S&P 500) ↔ IVV (iShares S&P 500)
VTI (Vanguard Total Market) ↔ ITOT (iShares Total Market)
VXUS (Vanguard International) ↔ IXUS (iShares International)
Individual stocks in same sector (but different companies)

Pro Tip: Keep a 'dance partner' fund for each position. When markets drop, swap between partners to harvest losses while maintaining exposure.

Step-by-Step Tax Loss Harvesting

1. Identify positions with losses (cost basis higher than current value)

2. Calculate potential tax benefit:

Short-term losses offset short-term gains (taxed as ordinary income)
Long-term losses offset long-term gains (lower capital gains rates)
Net losses can offset up to $3,000 of ordinary income
Excess losses carry forward indefinitely

3. Check wash sale implications (recent or planned purchases)

4. Sell the position at a loss

5. Immediately buy a similar (not identical) investment OR wait 31 days

6. Document everything for tax time

When Tax Loss Harvesting Makes the Most Sense

When you have realized capital gains to offset
When you're in a high tax bracket (22% or higher)
During market volatility or corrections
When transaction costs are low (commission-free trades)
When you have a large taxable brokerage account
Near year-end to maximize current-year benefit

Advanced Strategy: Loss Harvesting for FIRE

For those pursuing FIRE, tax loss harvesting becomes even more powerful:

Harvest losses during high-income working years
Carry forward losses to offset Roth conversion income in early retirement
Offset capital gains from portfolio rebalancing
Create tax losses to offset income from side hustles or consulting
Build up loss carryforwards as a 'tax shield' for future flexibility

Smart Move: In your last few working years, aggressively harvest losses to build up carryforwards that can offset Roth conversions in early retirement when your income is low.

Common Mistakes to Avoid

Triggering wash sales by buying too soon
Harvesting tiny losses (transaction time may not be worth $50 in tax savings)
Forgetting about state taxes (losses reduce state taxes too)
Not considering the bid-ask spread on the replacement security
Letting the tax tail wag the investment dog (don't sell just for taxes)
Forgetting to track your cost basis adjustments

Tax Loss Harvesting and Robo-Advisors

Many robo-advisors offer automated tax loss harvesting:

They monitor your portfolio daily for harvest opportunities
Automatically swap to similar ETFs
Track wash sale windows across all accounts
Typical cost: 0.25-0.30% annual fee
Can be worth it for accounts over $50,000

DIY vs. Automated: Which Is Right for You?

DIY Tax Loss Harvesting is best if:

You have a simple portfolio (few holdings)
You check your portfolio regularly
You want to minimize fees
You enjoy managing your investments

Automated services make sense if:

You have a complex portfolio
You want hands-off management
Your account is large enough to justify fees
You value convenience over cost

Tax loss harvesting is one of the few 'free lunches' in investing—if done correctly. By systematically harvesting losses during market downturns, you can reduce your tax bill, improve after-tax returns, and maintain your desired investment exposure. Whether you do it yourself or use automated tools, tax loss harvesting should be part of every sophisticated investor's playbook. Start looking for opportunities, especially during volatile markets, and turn those paper losses into real tax savings.