Why prioritization matters

Tax-loss harvesting and rebalancing are both routine portfolio maintenance tasks, but they have different goals and different tax consequences. Rebalancing keeps your risk profile aligned with plan targets; tax-loss harvesting improves tax efficiency by generating realized losses that offset taxable gains or up to $3,000 of ordinary income per year (with unused losses carrying forward). Doing one before the other—or doing both in a coordinated way—can materially change your tax bill and portfolio exposures.

This guide gives clear, practical rules you can apply when deciding whether to harvest losses or rebalance first. The rules assume U.S. federal tax treatment and reference basic IRS guidance on capital gains/losses and wash sales (see links below). This is educational only; consult your tax advisor for personalized advice.

Sources: IRS Publication 550 (Investment Income and Expenses) and IRS pages on capital gains and wash sales (irs.gov). For plain-language investing context, see Consumer Financial Protection Bureau resources on investing (consumerfinance.gov).

Core prioritization rules (step-by-step)

  1. Prioritize rebalancing inside tax-advantaged accounts first
  • Rationale: Trades inside IRAs, 401(k)s, Roth IRAs and other tax-advantaged accounts do not create immediate taxable events. Rebalancing there preserves your target allocation at no tax cost.
  • Action: Rebalance these accounts to targets before touching taxable brokerage accounts.
  1. In taxable accounts, check realized gains/losses before acting
  • If you already realized significant gains this year (e.g., you sold concentrated winners or received capital gain distributions), prioritize tax‑loss harvesting to offset those gains.
  • If you have no realized gains and are unlikely to realize gains this year, rebalancing may be the simpler path—especially if you can rebalance using new cash flows or transfers instead of selling winners.
  1. Use cash flows (contributions, dividends) to rebalance when possible
  • Avoid taxable trades by directing new contributions or dividends to underweight asset classes. This is a low‑cost, tax‑efficient first step before selling winners.
  1. Apply a threshold + calendar approach for routine maintenance
  • Threshold rule: Rebalance only when an allocation deviates by more than a set band (commonly ±5 percentage points). This reduces trading and tax churn.
  • Calendar rule: Combine with an annual review (or semiannual) to catch smaller drifts. Use thresholds to avoid unnecessary tax events.
  1. When you must sell in a taxable account, prefer tax-loss harvesting when it offsets higher‑tax gains
  • Prioritize harvesting losses that offset short-term gains first because short-term gains are taxed at ordinary income rates.
  • If you expect the taxpayer to be in a lower tax bracket in a future year, consider realizing long‑term gains deliberately in that low‑tax year rather than harvesting losses that might be more valuable later.
  1. Watch the wash‑sale rule
  • The IRS disallows a loss for tax purposes if you buy a “substantially identical” security within 30 days before or after the sale that generated the loss. IRS guidance and Publication 550 describe the rule—plan replacements carefully (e.g., use ETFs with different composition or sector peers) or wait 31+ days.
  1. Use specific lot identification and tax-lot selection
  • When selling in taxable accounts, use specific identification to choose lots that minimize taxable gains or maximize harvested losses. Brokerages allow lot selection (e.g., sell lots purchased at the highest cost basis) if you instruct them.
  1. Consider partial rebalancing
  • When rebalancing would create large taxable gains, rebalance only part of the difference and use new cash flows to gradually restore the target. This smooths tax impact while maintaining discipline.

Practical decision flows (short scenarios)

Scenario A — You sold a large appreciated position earlier this year

  • Problem: You have large realized gains in 2025 and your taxable account is overweight equities.
  • Priority: Tax-loss harvest in taxable accounts to offset those realized gains. After harvesting, re-establish target allocation using replacement securities or new cash. If no replacement is available, rebalance inside tax-advantaged accounts.

Scenario B — No realized gains; allocations drifted after a rally

  • Problem: Your equities allocation drifted from 60% to 75%; you have no gains to offset.
  • Priority: Rebalance using new contributions, or rebalance inside tax-advantaged accounts first. If you must sell taxable winners, weigh the tax cost against the risk of staying overweight; partial rebalancing is a good compromise.

Scenario C — You hold losses in several lots and want to keep exposure

  • Problem: You have lots with losses but want to keep similar market exposure.
  • Priority: Harvest losses and immediately replace exposure with a non‑substantially identical ETF or mutual fund to avoid the wash‑sale rule, or wait 31+ days to repurchase the original security.

Technical considerations that change prioritization

  • Short-term vs long-term distinctions: Short-term gains are taxed at ordinary income rates, so harvesting losses to offset short-term gains provides higher tax value than offsetting long-term gains.

  • Loss carryforwards: If you already have ample capital loss carryforwards, immediate harvesting is less valuable. You might prefer to rebalance and conserve loss harvesting for years when you need offsets.

  • State taxes and AMT: Consider state capital gains rules and whether large sales could trigger alternative minimum tax (AMT) or state surtaxes.

  • Portfolio concentration: If concentration risk threatens your financial plan, remediate it even if it triggers taxes. Risk control can outweigh tax minimization.

  • Transaction costs and bid-ask spreads: High trading costs can negate tax savings from small harvests.

Tools and execution tactics

  • Use ETF or sector proxies (that are not “substantially identical”) to maintain exposure after harvesting. See internal guidance on tax-loss harvesting best practices for examples and replacement choices: Tax-Loss Harvesting Best Practices for Tax-Aware Investors.

  • Automate rebalancing inside tax‑advantaged accounts and set threshold triggers for taxable accounts. Our internal article on tax-aware rebalancing covers schedules and trigger rules: Tax-Aware Rebalancing: How to Rebalance Without Excess Taxes.

  • Use broker lot accounting and specific identification. When selling, instruct the broker which tax lots to use (e.g., highest cost basis first) to control realized gains.

Example checklist before making trades (quick pre-trade control)

  1. Which account type will trade? (Taxable vs IRA/401(k)/Roth)
  2. Do you have realized gains this tax year to offset? (Yes → favor tax harvesting)
  3. Can new cash flows or dividends be used to rebalance instead of selling? (Yes → use them)
  4. Will a sale create short‑term gains? (If yes, evaluate urgency)
  5. Are replacement securities available that avoid wash‑sale risk? (If no, consider waiting)
  6. What are transaction costs and bid‑ask spreads? (If high, avoid churning)

Common mistakes to avoid

  • Harvesting losses that produce negligible tax benefit after fees and re-investment costs.
  • Rebalancing taxable accounts automatically without checking tax consequences or using cash flows first.
  • Violating the wash‑sale rule by repurchasing substantially identical securities within 30 days.
  • Ignoring lot selection tools that reduce taxable gains.

Final recommendations

  • Rebalance tax‑advantaged accounts first because there’s no tax friction.
  • In taxable accounts, prioritize tax‑loss harvesting when you have realized gains or when harvesting offsets short‑term gains taxed at higher rates.
  • Otherwise, prefer tax‑aware rebalancing: use cash flows, partial trades, and lot selection to minimize taxes while keeping allocations close to target.

For more detailed workflows and examples, see our related pages on tax-loss harvesting practices and tax‑aware rebalancing linked above.

Disclaimer: This article is educational and does not constitute individualized tax or investment advice. Tax laws change; consult a qualified tax advisor or financial planner before implementing these strategies.

Authoritative sources