It’s easy to get caught up in your emotions as the markets slump to newer lows daily. The urge to do something, such as sell off your assets, can be overbearing. Sadly, this may only cement your loss position.
Fortunately, you can take certain steps in a bear market to improve your long-term financial outlook. Tax-loss harvesting is just one of them. This post explores tax-loss harvesting, who should use it, and the caveats in claiming it.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is a process investors use to lower the tax bill, essentially “harvesting” from the losses you incur during the market dips. In other words, if an investment has decreased in value since you purchased it, it may have incurred “taxable” losses.
Investors who hold investments in a loss position can opt to sell them at a loss – and use those losses as deductions against their income during the current tax year or future years when they sell other investments at a profit.
You may also use the tax deductions for other investment opportunities such as pooling for your mortgage.
Why Should You Consider Tax-Loss Harvesting?
It may seem counterintuitive to sell low rather than the industry’s mantra of “buy low, sell high.” But the tax code may allow you to “exchange” your investment with other products that aren’t substantially identical and write off the losses in your income tax.
You can enjoy a reduced tax bill, potentially over a multi-year period. Realizing these losses offsets your current capital gains, and you can reduce your tax burden by up to $3,000 annually on your returns. You may carry any losses not covered in your current tax year forward to future years.
Where’s the Catch?
Tax-loss harvesting allows investors to sell losing positions and use the losses to offset realized gains to lower their tax bills. The caveat is trying to avoid the Internal Revenue Service’s “wash-sale” rule.
The IRS regulation on tax loss claims on capital gains indicates that you cannot deduct a loss and turn around and buy a “substantially identical” investment product for thirty days after the sale.
It means you can’t sell a stock, turn around, buy it back, then request a deduction on the loss. Significantly similar products such as call options on said stock can cause the IRS to deny the tax-loss claim.
The rule also prohibits a spouse from selling a stock with their partner and buying it back in their personal accounts. You also can’t sell the product in your brokerage account at a loss and buy it back in your retirement accounts.
Watching Out for the Caveats
The caveat creates a problem for investors who wish to maintain a similar profile of industry exposure for their investment portfolio. It can be tricky to pick stocks or products to replace the loss-making investment. You should consider consulting your tax advisor before taking this drastic measure.
When Should You Consider Tax-Loss Harvesting?
While tax-loss harvesting can help you reduce your taxes, it’s important to note that it’s not for everyone. Here are pointers you should know about prior to using this technique.
First, tax-loss harvesting is meant to be used only in taxable accounts — not 401(k)s or IRAs. It means that if you’re trying to save for retirement, reduce your debt amount, and take advantage of tax benefits such as Roth conversions, then tax-loss harvesting won’t work for you.
Moreover, tax-loss harvesting is perfect if you anticipate your tax bracket will soon be lower. It can result from retirement or an expected income drop. As capital gains below the 22% income tax bracket aren’t taxed, tax-loss harvesting may not be ideal for investors in lower tax brackets.
Circumstances In Which You Should Consider Using Tax-Loss Harvesting
Here are some scenarios where tax-loss harvesting may be useful:
Cutting Back Concentrated Stock Positions
Your employer’s stock purchase plan can lead to you holding large stock positions. The bear market can present an opportunity to offload some of these positions and use the benefits to diversify your other individual holdings.
Dumping High-Cost Funds
The management cost among different brokerage firms may vary significantly. The market dips may present an opportunity for tax-loss harvesting and to switch to lower-cost funds with better performance over the long term.
If your positions drift significantly from your target positions, tax-loss harvesting may present an opportunity to stabilize your portfolio with tax savings.
You may need to assess your current financial plan to determine whether tax-loss harvesting aligns with your long-term goals.
How Do You Know If Tax-Loss Harvesting Is Right for You?
The best way to figure out whether tax-loss harvesting is right for you is to talk to an advisor who knows your entire financial picture. Whether you’re in a loss position or not depends on many factors, including the amount of investment income you have and how much in taxes you paid last year.
If you aren’t sure what effect tax-loss harvesting will have on your taxes, talk with a pro who can help put things into perspective.
Tax-Loss Harvesting in a Bear Market
Tax-loss harvesting is all about taking advantage of losses in your investment portfolio to lower your tax bill. Whether you talk with an advisor or do it yourself, the most important thing is to ensure the process makes sense for your specific situation.