Methods to maximize tax-loss harvesting success

We break down the complexities of TLH and discuss the factors an investor might consider to help improve outcomes.

Tax-loss harvesting is a way to convert investment losses into tax savings. When securities held in a taxable account are sold for less than their original cost, the investor can claim a capital loss. This loss is then used to offset capital gains in other parts of a portfolio and/or up to $3,000 of ordinary income. If the losses exceed the gains and the $3,000 limit, the additional losses are carried forward and can offset capital gains and income in future years.

However, results for investors can vary. We consider TLH value in three categories: features specific to an investor, features an investor can influence, and features an investor can’t influence (for example, market conditions). Each category explains roughly one-third of the variance.

The effectiveness and value of TLH depends on the ability to generate losses, convert those losses into tax savings efficiently, and reinvest the tax savings in the stock market. Investors who don’t achieve all three may not fully benefit from TLH.

"Investing requires exposure to volatility for effective tax-loss harvesting. Without it, investors can’t use losses to offset taxes,” Paradise said. “However, realizing these losses only benefits those with enough gains or a high tax rate. Ultimately, the success of this strategy hinges on reinvesting the tax savings wisely to fully capitalize on the benefits.”

Vanguard research found that the most important thing an investor can do to maximize the potential for TLH success is to reinvest tax savings in the portfolio. Features an investor can influence, including discipline in reinvesting, portfolio granularity (for example, direct indexing), recurring investments, and harvest frequency, account for the largest component of the outcome (37%).

Tax-loss harvesting is not a free lunch. Investor awareness of risks should go hand in hand with care and planning of a TLH strategy because these risks may devalue the portfolio in certain scenarios:

• Wash sales: The IRS wash sale rule prohibits investors from claiming a loss on a sale if they purchase a “substantially identical” security within 30 days before or after the sale.¹ Investors should select replacement securities that maintain a desirable but distinct exposure.

• Ossification: Reinvesting proceeds from harvested investments lowers the portfolio’s cost basis, making future TLH harvesting more challenging when combined with the historical upward trend of markets.

• Capital gains availability: Investors need enough capital gains to convert harvested losses into tax savings, but it can be tricky to predict future capital gains. Investors should consider potential future events such as selling investments to finance a home purchase or selling a personal business that can generate significant gains as part of a long-term financial plan.

• Tax rate changes: Deferring taxes may be disadvantageous if tax rates increase in the future. Avoid TLH when facing “0% tax rates,” in which capital gains or income are too low to incur taxes. Predicting future tax rates can be difficult because financial circumstances and the tax code can change.

• Market environment: While rising markets can enhance the benefits of TLH, exiting the market following a sharp downturn can lead to losses.

• Profile analysis: Higher-net-worth investors are more likely to reap the rewards of TLH. Daily harvest screening, reinvesting tax savings, and making ongoing contributions can help investors who pursue this strategy.

While investors can control a portion of the factors that can influence TLH outcomes, some elements, such as market volatility, remain beyond their control. That’s why it’s crucial for investors to approach TLH with realistic expectations and understand the risks, especially if they are currently in a lower tax bracket. The key to maximizing TLH benefits lies in effectively reinvesting any tax savings in the portfolio. This way, it can help grow an investor’s money over time. 

• Tax-loss harvesting: Why a personalized approach is important (16-page PDF, issued July 2024)
• Tax-saving strategies for the savvy investor (article, issued March 2024)
• Costs matter, and other axioms on tax-efficient investing (article, issued March 2024)