This is a guest post from Bo Lu, CEO of FutureAdvisor . a fee-only registered investment advisor.

Research shows that diligent attention to taxes can save an investor $6,057 per year over 25 years on a $200k investment.

What is tax loss harvesting?

In simple terms, tax loss harvesting is the act of paying diligent attention and capturing momentary downturns in the market in order to reduce your tax bill. It provides three key benefits:

• It reduces this year’s tax bill from investments by allowing you to defer taxes into the future, sometimes indefinitely.

• It reduces this year’s overall tax bill because you can use up to $3,000 of tax losses harvested to reduce other taxable income.

• It reduces future tax bills. If you can’t use all your harvested losses this year, you can roll losses over to be used in future years until you use it all up.

How much would you be saving?

Using academic analysis presented in an in-depth paper by Andrew L. Berkin and Jia Ye, we’ve built a calculator that shows you how effectively the technique can reduce the tax burden of an investment. By entering an amount of money that you hypothetically invested at the beginning of 1988 in the S&P Index, the graph shows your investment’s value over 25 years, with and without tax loss harvesting diligently applied. This demonstrates that your taxable portfolio can save you dramatic amounts when it’s managed efficiently, especially as time goes on.

Play around and see for yourself:

How does it work?

The easiest way to understand the basic principle of the technique is to look at a simple example.

Let’s say your portfolio consists of a $50,000 investment in Mutual Fund X. Then, in a down year, the value of that holding decreases to $45,000. Most investors in this situation would do nothing. But, an investor implementing tax loss harvesting would sell the $45,000 holding in Mutual Fund X and invest it instead in a similar but not identical fund. In doing so, this investor has ‘harvested’ the $5,000 loss for tax purposes, though in reality little actually changed – he or she still owns $45,000 of a mutual fund in that asset class, just as if they did nothing. (Note that the investor has to be careful not to buy back Fund X within 31 days, to comply with the wash sale rule).

Now, because you have booked that $5,000 as a capital loss, at tax time, you can deduct this loss from capital gains elsewhere in your portfolio, reducing the amount of capital gains tax you owe in a year when your portfolio nets an overall profit. In a year where you have more capital losses than gains, the IRS allows you to apply up to $3,000 in losses against your other income and carry over the remaining losses to count against future years’ incomes.

What can you do with this knowledge?

Your portfolio likely already contains some tax losses, here and there, that can be harvested to reduce this year’s tax bill, and future bills. As you saw in the above example, it’s worthwhile, but not simple; you’ll need all your tax lot and cost basis information and a spreadsheet. And, to get the most value, you’ll need to diligently monitor your portfolio as markets move, to take advantage of opportunities that arise.

This is where a good financial advisor comes in: a traditional financial advisor or a digital wealth manager can do this for you. If you prefer human financial advisors, find one near you and ask them if they offer automated tax loss harvesting as part of their wealth management service. Make sure that they don’t just do it ‘once a year’ – research shows you can capture a lot more value if you do it monthly (Berkin & Ye, 2003). Alternatively, digital wealth management services such as FutureAdvisor offer automated tax loss harvesting as part of their overall portfolio management services. For $19 / month, these services will take care of tax loss harvesting (along with rebalancing) for you.

In the end, whether you choose to do it yourself, find a local financial advisor to help you, or choose a digital wealth management service to do it automatically, you’ll know that next time the markets take a momentary downturn and everyone else wrings their hands, you can be confident in the fact that these are merely par for the course in long term investing. And at least your tax bill is being reduced as it happens!