What is Tax-Loss Harvesting? (Plain English Definition)
Definition: Tax-loss harvesting is the strategy of selling investments at a loss to offset capital gains taxes, then reinvesting in similar assets to maintain market exposure.
Tax-Loss Harvesting Explained Simply
Tax-loss harvesting involves intentionally selling an investment that has declined in value to realize a capital loss. This loss can offset capital gains from other investments, reducing your overall tax bill. After selling, you reinvest in a similar but not identical security to maintain your market exposure. The IRS wash-sale rule prohibits buying a substantially identical security within 30 days, or the loss is disallowed.
For example, if you own an S&P 500 ETF that has declined in value, you could sell it, harvest the tax loss, and immediately buy a total stock market ETF or a different S&P 500 ETF to maintain similar market exposure. The two funds are not considered substantially identical because they track different indices, so the loss is allowed.
Tax-loss harvesting is most valuable in the early years of investing when you have recent purchases that may temporarily show losses. It is also particularly useful during market downturns when many positions are underwater. Robo-advisors like Betterment and Wealthfront offer automated tax-loss harvesting as a core feature.
Tax-Loss Harvesting Example
You bought the Vanguard S&P 500 ETF (VOO) for $50,000, and it has declined to $42,000 -- an $8,000 loss. You sell VOO, realizing the $8,000 loss, and immediately buy the iShares Core S&P 500 ETF (IVV) for $42,000. Your market exposure is virtually identical. The $8,000 loss can offset $8,000 in capital gains elsewhere in your portfolio. At a 15% tax rate, that saves you $1,200 in taxes. After 31 days, you could switch back to VOO if desired.
Why Tax-Loss Harvesting Matters for ETF Investors
Tax-loss harvesting is one of the few strategies that can add measurable value to an ETF portfolio without taking on additional risk. Research suggests it can add 0.5-1.5% per year in after-tax returns, depending on market conditions and portfolio size. For ETF investors, the abundance of similar but non-identical ETFs makes tax-loss harvesting particularly easy. You can swap between ETFs tracking different indices while maintaining nearly identical market exposure. This is a significant advantage of ETF investing that is not as easily accomplished with mutual funds or individual stocks.
Tax-Loss Harvesting vs Tax Efficiency
| Tax-Loss Harvesting | Tax Efficiency |
|---|---|
| Tax-loss harvesting is the strategy of selling investments at a loss to offset capital gains taxes, then reinvesting in similar assets to maintain market exposure. | See full definition of Tax Efficiency |
While tax-loss harvesting and tax efficiency are related concepts, they serve different purposes in the world of ETF investing. Understanding both terms helps you make more informed decisions about which funds to include in your portfolio and how to evaluate their performance.
Related Terms
Deepen your understanding of ETF investing by exploring these related concepts:
Tax Efficiency
Tax efficiency measures how well an investment minimizes the taxes investors owe, with ETFs being among the most tax-efficient investment vehicles.
Capital Loss
A capital loss occurs when you sell an investment for less than you originally paid for it.
Capital Gain
A capital gain is the profit earned when you sell an investment for more than you originally paid for it.
Roth IRA
A Roth IRA is a retirement account funded with after-tax dollars, where investments grow tax-free and qualified withdrawals in retirement are also tax-free.
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