No one—except the rare contrarian investor—is ever happy about a falling stock market. Large, rapid corrections can wreak havoc on both taxable and tax-deferred portfolios. Market corrections can be especially troublesome for investors approaching retirement who may not have enough time for the markets to fully recover before they begin transitioning from saving to spending.
Still, for most investors, the best thing to do is usually nothing at all. If you have time on your side, avoid the urge to panic, and simply ride out the storm. Attempting to time the markets by moving to cash before a steep decline and then moving back into stocks before a recovery will, more often than not, leave you worse off than if you had done nothing.
Bear markets do, however, present a unique opportunity for investors to realize some extensive tax benefits through the process of tax-loss harvesting.
What Is Tax-Loss Harvesting?
Tax-loss harvesting involves selling securities held in your taxable accounts that have declined in value (recording a paper loss for tax purposes) and then reinvesting the proceeds to purchase a similar but not substantially identical security that meets your investment needs and asset allocation strategy. Any losses you realize are first used to offset any capital gains you incurred during that same calendar year. Any remaining losses (up to $3,000 per year) can then be deducted from ordinary income when you file your income taxes. Losses that exceed the $3,000 annual limit can be carried forward to future tax years.
The following is a simple hypothetical example to show how tax-loss harvesting might benefit an investor: Let’s assume that this past November you invested $100,000 in an exchange-traded fund (ETF) that tracks the S&P 500 Index. In March, however, the market dropped 20% and the original investment is now worth $80,000. As a result, you decide to sell the investment to lock in the $20,000 loss for tax purposes. You then turn around and use the $80,000 in sale proceeds to purchase a similar (but not substantially identical) ETF that tracks the NASDAQ 100 Index.
Now, suppose that by the end of this year, the stock market has rallied significantly and the value of the NASDAQ 100 ETF you bought has climbed to $110,000. You would have effectively realized a substantial loss to use for tax purposes, while the value of your original investment would have increased—a win-win scenario.
Avoiding Wash Sales
When you are deciding on one or more investments to replace an investment that you sell to harvest a loss, it’s critical that you pay close attention to the requirement that the new investment be “similar but not substantially identical.” You can’t simply repurchase the same security or even one that’s nearly identical (for example, a Vanguard S&P 500 fund and a Fidelity S&P 500 fund) unless you wait at least 30 days between the original sale and the subsequent purchase. If you do, the IRS wash-sale rule states that your tax write-off from the sale would be disallowed.
Offsetting Short- and Long-Term Gains
There are specific rules and restrictions about how investment losses may be used to offset investment gains. Long-term losses must first be applied against long-term gains, and short-term losses against short-term gains. You can then apply any excess losses in one category to the other category, and if there are still remaining losses, you can carry them forward to be used in future tax years. Even if you don’t have gains in a particular year, the IRS allows you to apply up to $3,000 of harvested tax losses to reduce your taxable ordinary income each year.
Periodic and proactive tax-loss harvesting can be an effective way to reduce your tax burden and boost your after-tax return. It’s a practice that can be especially helpful when there is a swift and sudden market correction. As with any strategy that has tax implications, however, you should always consult your tax advisor before initiating any tax-loss harvesting transactions.
Key Takeaways
During periods of market correction, investors may benefit from “locking in losses” by selling certain investments and then purchasing similar ones.
This process, known as tax-loss harvesting, can be used to help offset current (and potentially future) portfolio gains and reduce your tax liability.
Your tax advisor and your Eagle Strategies advisor can help you identify tax-loss harvesting opportunities and make sure you adhere to all the rules and restrictions.
