Tax Loss Harvesting: How to Find a Silver Lining in Declining Markets

Certified Financial Planner CFP Retirement Advice Retirement Planning Taxes What is Asset Management? November 30, 2022 Author: Woody Derricks

Tax Loss Harvesting: How to Find a Silver Lining in Declining Markets

When the stock market is experiencing a rough patch, it’s easy to feel negative about your investments. In reality, you’re getting some great opportunities. One opportunity is buying stocks on sale if you continue regularly putting money in the market. Another is the chance to turn some of those paper losses into something positive through a technique called Tax Loss Harvesting.

Turn a Loss into Tax Savings
No one likes it when stocks drop in value, but bear markets are an unavoidable part of long-term investing. If you sell when your stocks are down, you will generate a tax loss. But that’s an actual loss, so it is not great for your financial health. However, there is a way to turn that into a good thing as long as you do it right.

It’s What You Do Next That Counts
Fortunately, taking one additional step can turn that loss into something positive. After you sell your losing position, you can redeploy those funds into a different security in the same industry or sector. That way, you can still participate in a recovery, but you’ll lock in that loss for tax purposes. That loss will lower your tax bill, increasing your net returns.

Tax Loss Harvesting Example
Here’s an example. Let’s say you’re holding a technology stock at a $10,000 loss. You sell it and realize a $10,000 taxable loss. You then immediately reinvest those funds into a tech stock ETF that holds that stock, plus other competitors and peers. You end up with a similar investment position and a $10,000 tax loss, which will offset taxable gains for the year. This lowers your tax bill.

What if you have no taxable gains this year? The good news is that you can use $3,000 of tax losses yearly to offset regular income. If you don’t use it all, whatever is left rolls over for use in future years.

Bottom line: you’ll save on taxes and still be invested in a very similar fashion. Win/win!

Here are some other things to keep in mind about tax loss harvesting:

  • Did you have a low-income year? If so, you may have long-term capital gains that fall into the 0% tax bracket, so you might want to focus on taking gains rather than offsetting them with losses. In this case, it might make sense to avoid tax loss harvesting.
  • Tax loss harvesting only works in taxable accounts. You can’t deduct losses in retirement accounts such as an IRA or a 401(k).
  • You and/or your spouse cannot repurchase the same security within 30 days before or after the tax loss sale (even in other accounts such as an IRA or 401(k)). If you do, you incur a “wash sale,” and that taxable loss will not be allowed this year (although it will adjust the cost basis on the new purchase).
  • To avoid a wash sale, you cannot purchase a security that is “substantially identical.” If you’re selling a stock, that can mean buying a competitor’s shares, positioning you to benefit when the sector rebounds. Or you can replace an individual stock with an ETF that gives you similar exposure but with more diversification.

Don’t Forget:  A Gain is Always a Good Thing
One caution: many hesitate to sell any part of a winning position because they fear the tax consequences. Remember that actual gains are more important than the capital gains tax, which is always just a fraction of a long-term gain. Don’t ever let fear of taxes prevent you from selling and turning paper profits into real profits when that fits into your financial plan.

Key Takeaway
We work with clients’ CPAs to develop tax strategies such as tax loss harvesting. If you want to try tax loss harvesting, be sure to coordinate with your financial advisor and tax professional to make sure you can get the full benefit.

The opinions voiced in this material are for informational purposes only and are not intended to provide specific advice to any individual. Consult your legal, tax, and/or financial advisor to determine what is appropriate for your situation.

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