Tax-Loss Harvesting and the Year-End Playbook

A falling market is unpleasant, but for an investor with a taxable account it carries one consolation: a loss you have not yet sold can be turned into a tax deduction without leaving the market. That is tax-loss harvesting. Done carefully it lowers this year's tax and can keep doing so for years; done carelessly it is undone by the wash sale rule or simply moves tax from today to later. This chapter covers how losses are counted, what the rule forbids, how to time harvesting through the year and especially at year-end, and when harvesting is not worth it.

How capital losses are used

Sell an investment in a taxable account for less than you paid, and you have a capital loss. Losses are applied in a fixed order.

1. Against gains of the same kind. Short-term losses first offset short-term gains; long-term losses first offset long-term gains.
2. Against gains of the other kind. Any net loss left on one side offsets net gain on the other.
3. Against ordinary income. If losses exceed all gains for the year, up to $3,000 of the excess can be deducted against wages and other income (half that if married filing separately).
4. Carried forward. Anything left over carries forward to future years with no time limit, and is used the same way each year until it runs out.

The order matters because short-term gains are taxed at your full rate. A loss that wipes out a short-term gain saves tax at your marginal rate; one that offsets a long-term gain saves at 0%, 15% or 20%.

What the deduction against income is worth

Without losses this filer owes $9,870. Harvesting enough losses to deduct the full $3,000 against income brings the tax to $9,210, because the deduction comes off the top bracket of 22.0%. A larger harvested loss does more: it can offset gains this year and the carryforward can cover the same deduction against income in later years. Run your own figures through the capital gains harvesting calculator.

The wash sale rule

The tax code does not let you sell at a loss and immediately buy the same thing back. Under the wash sale rule, a loss is disallowed if you buy a "substantially identical" security within 30 days before or after the sale, a window of 61 days in all. The rule reaches further than people expect:

• Purchases in any of your accounts count, including an IRA or Roth IRA, and so do purchases by your spouse. A replacement bought in an IRA is the worst case: the IRS has ruled the loss is lost for good, not deferred.
• Automatic reinvestment counts. A dividend reinvested into the fund you just sold at a loss, within the window, triggers a partial wash sale. Turn off reinvestment in a fund you plan to harvest.
• A disallowed loss is usually postponed, not lost. In a taxable account, the disallowed loss is added to the cost basis of the replacement shares, so you recover it when those are sold.

To stay invested while harvesting, buy something similar but not substantially identical: for example, sell one company's S&P 500 index fund and buy a total-market fund, or a fund tracking a different large-company index. The IRS has never published a precise test for "substantially identical"; two funds from different companies that track the same index are a grey area that many investors avoid. Shares of the same company, or options on them, are clearly identical.

Harvesting is mostly deferral

When you sell at a loss and buy a replacement, the replacement's cost basis is lower than the original's. When you eventually sell it, the gain will be larger by about the amount you harvested. So most of the benefit is that tax is postponed, and the money saved can be invested in the meantime. Harvesting becomes a permanent gain in three situations:

• Rate arbitrage. The loss saves tax at a high rate now (against short-term gains or ordinary income) and the larger gain is later taxed at a lower rate (long-term, or the 0% band in a low-income year).
• Step-up at death. Investments held until death get a new cost basis equal to their value then, and the deferred gain is never taxed (chapter 7).
• Giving. Low-basis shares donated to charity are never taxed on their gain (chapter 5).

The flip side: if you expect to be in a higher bracket when you sell, or you lower your basis on shares you will soon need to sell, harvesting gains you little.

Harvesting through the year, and the year-end playbook

Markets do not wait for December. Losses that appear in a spring sell-off may be gone by autumn, so checking a taxable account for losses after any sharp fall, or when rebalancing, captures more than a single year-end review. Many investors use a threshold, such as a position down by a set percentage, rather than a date.

Year-end still deserves a routine, because the deadlines are real.

October: take stock. List each taxable position with its cost basis, gain or loss, and holding period. Look up the estimated year-end capital gain distributions of each mutual fund you own. Total the gains you have already realised this year, including those distributions, so you know what losses are worth.

November: act. Sell positions with meaningful losses and buy the replacements the same day so you stay invested. Choose the specific shares you sell: most brokers let you pick tax lots, and selling the highest-cost lots first realises the largest loss (or smallest gain). Selling just before a fund's distribution can also avoid a taxable payout, if the sale itself does not create a larger gain.

December: finish. Trades must execute by the last business day of the year to count for that year. Check that no purchase in any household account, including scheduled contributions and dividend reinvestment, falls within 30 days of a loss sale. Keep a record of each harvest, since your broker's Form 1099-B may not catch a wash sale caused by a purchase at another firm.

The opposite move: harvesting gains. In a year when your taxable income is low enough that long-term gains fall in the 0% band, at or below $49,450 of taxable income for a single filer or $98,900 on a joint return, selling winners and buying them straight back resets the basis higher at no federal tax. The wash sale rule applies only to losses, so this is allowed.