Tax-Loss Harvesting: Mechanics and Benefits
Tax-loss harvesting (TLH) is the practice of selling securities at a loss to realize a capital loss for tax purposes, then immediately reinvesting in a similar (but not substantially identical) security to maintain market exposure. The realized loss offsets capital gains elsewhere in the portfolio (or up to $3,000 of ordinary income annually), deferring tax liability to the future. The benefit is not tax elimination but tax deferral: by deferring a tax payment now and keeping the money invested, you earn returns on money that would otherwise have gone to the IRS. The value of TLH depends on: your capital gains tax rate (the higher the rate, the more valuable the deferral), how long the tax is deferred (longer deferral = more compounding on the preserved capital), and the difference in returns between the sold security and the replacement security. The wash-sale rule (IRS): you cannot deduct a loss if you purchase a 'substantially identical' security within 30 days before or after the sale. The 30-day window applies on both sides of the sale. To avoid wash-sale disallowance: replace a sold ETF with a different fund tracking a similar but not identical index. Example: sell Vanguard Total Stock Market ETF (VTI, tracks CRSP US Total Market) and immediately buy iShares Core S&P Total US Stock Market ETF (ITOT, tracks MSCI US Broad Market) — both are US total market funds but track different indices, likely avoiding wash-sale classification (though this is not guaranteed; consult a tax advisor).