Design Tax Loss Harvesting Plan

---
name: design-tax-loss-harvesting-plan
description: Use when reducing capital gains taxes in a taxable brokerage account — e.g., "what is tax-loss harvesting?", "how do I harvest losses?", "when should I TLH?", "wash sale rule?"
source: "IRS Publication 550 (Investment Income and Expenses); Vanguard \"Tax-loss harvesting: A portfolio and wealth planning perspective\" (2020); Betterment TLH research; Schwab tax strategy guides"
tags: [finance, investing, tax-loss-harvesting, capital-gains, tax-efficiency, taxable-account, wash-sale]
verified: true
---

# Design Tax-Loss Harvesting Plan

Systematically realize investment losses to offset capital gains and reduce current-year tax liability while maintaining portfolio exposure.

## Why This Is Best Practice

**Adopted by:** Tax-loss harvesting (TLH) is standard practice at every major wealth management firm. Wealthfront and Betterment built automated TLH into their core product as the primary quantified value-add over self-directed investing. Vanguard Personal Advisor Services includes TLH as a key service. The CFA curriculum covers TLH as an advanced after-tax return enhancement technique.
**Impact:** Vanguard research (2020) estimates systematic TLH adds 0–1.1% in after-tax return annually in a taxable account — timing and market conditions dependent. Betterment research shows cumulative TLH benefit of $15,000–$25,000 per $1M invested over 10 years. The benefit is front-loaded: losses harvested today defer taxes that would have compounded.
**Why best:** TLH converts unrealized paper losses into a real tax benefit without abandoning investment exposure. The investor maintains market participation (via a similar replacement security), reduces current taxable income (up to $3,000/year against ordinary income), and defers gains taxes — effectively getting an interest-free loan from the government.

## Steps

1. **Identify harvestable losses** — Review taxable brokerage account for positions where current value < cost basis (unrealized loss). Focus on: long-held positions now underwater, recently purchased positions hit by market correction, individual stocks with sector weakness.
2. **Calculate the tax benefit** — Tax saved = loss amount × marginal tax rate (use long-term rate for long-held positions if carried forward). A $20,000 loss at 20% LTCG rate saves $4,000 in future taxes.
3. **Apply the wash-sale rule** — IRS rule: you cannot buy a "substantially identical" security within 30 days before or after the sale. Wash sale voids the loss deduction. Substantially identical: same stock or fund, options on the same stock. Not substantially identical: similar-but-different ETFs (selling VTI and buying SCHB or SPY; selling VXUS and buying VEU).
4. **Execute the harvest** — Sell the losing position. Immediately reinvest proceeds in a similar (not substantially identical) fund to maintain market exposure. Do not sit in cash — the risk of missing a rebound exceeds the tax benefit.
5. **Track the new cost basis** — The replacement security's cost basis is the purchase price after the TLH event. When sold later, the embedded gain will be taxable. The TLH deferral is not elimination — it's a timing benefit.
6. **Offset gains first, then ordinary income** — Harvested losses first offset capital gains (dollar-for-dollar). If losses exceed gains: up to $3,000/year can offset ordinary income. Remaining losses carry forward indefinitely.
7. **Reinstate the original security after 31 days** — Optional: after 31 days (wash sale window clears), swap back to the original fund if preferred. Most investors keep the replacement indefinitely.
8. **Monitor throughout the year** — Best TLH opportunities arise after market corrections (March 2020, Q4 2022). Automated TLH platforms check daily; manual investors should check after any 10%+ drop.

## Rules

- Never let tax savings drive investment decisions — only harvest losses in assets you were willing to sell anyway or can replace with a suitable substitute.
- Track all wash-sale interactions across all accounts (IRA, spouse's account) — wash-sale rule applies across all accounts held by the same taxpayer.
- TLH has no benefit in tax-advantaged accounts (401k, IRA) — losses there are never deductible; only applicable in taxable brokerage accounts.
- The deferral benefit shrinks if you plan to hold the replacement security until death — stepped-up basis at death eliminates deferred gain anyway. Best for investors who expect to sell within their lifetime.

## Examples

**Market correction: $500k taxable account, equity down 15%:**
Position: $80k in VTI, purchased for $100k. Current loss: $20,000.
Action: Sell VTI; simultaneously buy SCHB (different issuer, similar large-cap US exposure, not substantially identical).
Tax benefit at 15% LTCG: $3,000 saved now (if offsetting existing gains) or carried forward.
After 31 days: optional — sell SCHB and repurchase VTI if desired.
Net result: identical market exposure maintained; $3,000+ tax deferral locked in.

## Common Mistakes

- **Triggering wash sale by repurchasing too soon** — Buying back VTI within 30 days of selling it voids the loss. Use a calendar reminder.
- **Harvesting short-term losses when long-term gain offset is available** — Short-term losses first offset short-term gains (taxed as ordinary income); that's the better use. Match loss type to highest-rate gain first.
- **Going to cash after harvesting** — Missing even a few days of market recovery can cost more than the tax benefit. Replace immediately with a similar fund.

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> **Finance disclaimer:** This skill encodes professional best practices for educational purposes. It is not financial advice. Consult a licensed financial advisor before making investment decisions.