Early Retirement Now

Tax Loss Harvesting: what is it and how large is the expected benefit?


Tax Loss Harvesting is the rage now. Robo-advisers do it for you, and every DIY saver should seriously consider the benefits. Let’s look at what Tax Loss Harvesting is, how and why it works and how large (or small) the expected benefits can be.

What is Tax Loss Harvesting?

Tax loss harvesting involves these four simple steps:

  1. Continuously monitor the taxable portfolio for tax lots that are underwater, i.e., have a cost basis above today’s value. Otherwise known as a capital loss. This can be a short-term or long-term loss.
  2. Sell those tax lots and immediately buy a similar asset (though not identical to avoid the IRS wash sale rule). One might also do the regular portfolio rebalancing at the same time.
  3. Up to $3,000 p.a. in such losses can be used to offset ordinary income and lower the tax burden. Any excess over the $3,000 can be carried forward and written off in future years.
  4. Reinvest the tax savings from step 3 and watch your portfolio grow even faster! Note: the benefit is not $3,000, but $3,000 times the marginal tax on ordinary income!

For more details on the implementation please refer to our DIY guide on how to be your own DIY Robo-adviser.

How and why does Tax Loss Harvesting work?

Tax Loss Harvesting Mechanics
The TLH excess return consists of three components and we can later see how much each one of them is really worth:

  1. Time value of money: you get a tax benefit today but may pay higher taxes later when you eventually liquidate the position in retirement. Even if the tax rate were to be the same in retirement (or even slightly higher) you stand to gain from TLH because the government gives you an interesting-free loan to invest the TLH proceeds over potentially many years. You increase your future tax liability by exactly what you harvest in benefit today. See the red bar in middle column vs. blue bar on the left in the figure above. But getting the benefit today is still valuable! The green bar in the middle column is the gain from TLH in that case, which is equal to the capital gains from investing the date 0 tax savings net of the capital gains tax on those additional capital gains (orange bar).
  2. Tax rate arbitrage 1: between ordinary income and long-term gains. If you do the TLH right, your future capital gains are taxed at the lower long-term capital gains rate, while the benefit from the tax write off today comes from the higher ordinary income marginal rate. You squeeze the orange and red tax liabilities and get to keep more for yourself, see right column in the chart above.
  3. Tax rate arbitrage 2: between currently high marginal rates and (hopefully) lower rates in retirement. Chances are that during your working years you have higher taxable income putting you into a higher tax bracket both on your federal and state tax return. Moreover, you might move from a high tax state (NY, CA) to a low or no-income-tax state (FL, NV). In the chart above, tax rate arbitrage squeezes the red and orange tax liability boxes even more and leaves more pure after-tax gain (green bar, right column) for you to keep. In the best possible case the future taxes are zero and you get to keep the entire loot! Woo-hoo!
Two Components of Tax Rate Arbitrage

Tax Loss Harvesting: Numerical Examples

Let’s look at some numerical examples to see how much we can expect to make from harvesting tax losses! The assumptions used in the calculations are:

What’s the most you can expect in extra annualized % return?

Let’s pick assumptions that would generate a large TLH benefit, so as to give TLH the best possible chance to succeed:

We call this person Mr. A:

Tax Loss Harvesting Estimated Gain: Mr. A
Most of the gain came from the tax rate arbitrage, especially the zero future tax rate (Tax Arbitrage 2), see chart below. But nevertheless, even in the absence of any tax arbitrage, there is money to be made from TLH. Almost $700 are simply due to the time value of investing the TLH proceeds over ten years. Thus, TLH is worthwhile even if the tax in the future were to jump up all the way to an insane 49.6%, equal to today’s high marginal rate. If in addition the future LT Capital gains tax were to stay at today’s Dividend/LT Cap Gains tax rate of 33.8% we gain another $700, with the remaining $1,350 coming from reducing the LT Capital Gains tax rate all the way to 0%.

Components of Mr. A’s Tax Loss Harvesting Gain

How much do we diminish the Tax Loss Harvesting benefit when we use consecutively less extreme assumptions?

Mr. A has a pretty impressive excess return from Tax Loss Harvesting. But his case is not typical at all. Very few people are in such a high tax bracket, and in addition Mr. A also had a very tiny investment portfolio and a large pile of tax losses relative to the portfolio value. This means the benefits of a $3,000 write-off are applied to a relatively small base, hence, the impressive increase in the % return.

Let’s see how that annual percentage tax alpha diminishes as we make the assumptions less and less beneficial for TLH.

Tax Loss Harvesting Gains Comparison for Mr./Mrs. A through H

Mrs. B: same as Mr. A but twice the portfolio value and twice the harvestable loss.

Mr. C: Five times the portfolio value and five times the harvestable loss as Mrs. B

Mrs. D: double the portfolio size and tax loss of Mr. C

Mr. E: Lower Tax loss available

Mrs. F: Lower current tax rates

Mr. G: Half-million dollar taxable portfolio with $25K in tax losses

Mrs. H: Same as Mr. G, but low current tax rate

If anybody has ideas for other robustness checks (Mr./Mrs. I,J,K,L,M,…) for us to check out please let me know. We might be able to reach Mr. T (see below, right) before Physician on FIRE reaches Dr. J (see below, left) in his Four (or Five?) Physician study.


The TLH benefits can be larger or smaller depending on several other factors, especially unrelated capital gains. If you have large additional short-term capital gains from other unrelated investments early on, you might do significantly better than we calculated, because you don’t have to wait to write off $3,000 every calendar year, but instead get the entire benefit upfront and thus a higher time value of money effect (higher Time Value of Money effect). But nobody in their right mind would voluntarily realize short-term gains when they face high marginal taxes, so unless there are circumstances where someone faces forced short-term gains this situation can’t be too common.

If you have large additional long-term gains from unrelated investments, you might do worse than we calculated. That’s because first you have to net your harvested capital losses against capital gains. Even the short-term losses are netted against long-term gains before they can be used to lower your taxable income! In the extreme case where long-term gains are already taxed at zero percent (Mrs. H in the example above) your entire tax losses might be wiped out for no gain at all. Thus, unrelated capital gains will inadvertently eliminate the Tax Rate Arbitrage 1 Effect between ordinary income and long-term capital gains.

Moreover, caution with average vs. marginal benefits. The benefit from TLH of the marginal dollar invested is most likely below the average benefit. Let’s take the comparison between a Roth IRA vs. a taxable account (see our comparison calculations here): normally a Roth IRA would easily beat a taxable account without TLH because dividends and capital gains are taxed in the taxable account. But the difference in returns could be small if capital gains are realized in retirement at 0%. TLH could make the taxable account more attractive or the marginal benefit could be so small to keep the Roth IRA ahead. Whether to put those additional $5,500 into a Roth IRA or taxable account crucially depends on the individual circumstances and the marginal benefit, not the average over the whole portfolio!