Turn market downturns into a tax advantage. Here\'s how tax-loss harvesting works and when to use it.
Tax-loss harvesting (TLH) is the practice of selling an investment that has declined in value to realize a capital loss, then immediately reinvesting in a similar (but not identical) fund to maintain your market exposure. The realized loss can then be used to offset capital gains elsewhere in your portfolio — reducing your tax bill.
It sounds complicated, but the concept is straightforward: you're essentially converting paper losses into real tax savings without changing your long-term investment strategy.
Say you invested $10,000 in VOO (Vanguard S&P 500 ETF) and the market drops 15%. Your holding is now worth $8,500 — a $1,500 paper loss. You sell VOO and immediately buy IVV (iShares S&P 500 ETF), which tracks the identical index. You've harvested a $1,500 tax loss while remaining fully invested in essentially the same portfolio.
The IRS has a critical rule you must follow: you cannot buy a "substantially identical" security within 30 days before or after the sale. Selling VOO and buying VOO back immediately doesn't work — that's a wash sale, and the loss is disallowed.
However, selling VOO and buying IVV (both track the S&P 500 but are different funds from different providers) is generally considered acceptable by most tax professionals, since they're not "substantially identical." Always consult a CPA on your specific situation.
Some platforms like Betterment and Wealthfront offer automated tax-loss harvesting as a feature. If you're managing your own index fund portfolio, you'll need to do it manually — typically once or twice a year when significant losses appear, or after major market downturns.