Jesse Casson | Digital Vision | Getty Images
Stocks slide. But there may be a silver lining for investors.
An investment loss represents an opportunity to reduce your annual tax bill, through a mechanism called tax loss harvesting.
Here’s the basics: you sell an investment that’s in the red, then use that investment loss to offset the winners’ gains, thereby reducing or eliminating annual capital gains taxes.
There are additional benefits: if losses exceed annual gains, investors can use the remainder to offset up to $3,000 of ordinary income (like wages) from federal taxes. Anything left over can be carried forward to future tax years, to offset capital gains tax or ordinary income tax.
Many investors may be able to take advantage of this strategy in today’s market.
Major U.S. stock indexes have fallen for at least five straight weeks as investors grapple with potential economic headwinds like war, inflation and rising interest rates. The S&P 500 Index is down more than 15% in 2022. The Dow Jones Industrial Average is down more than 10% and the tech-heavy Nasdaq Composite is down more than 24%. Stocks extended their losses on Monday morning.
“Maybe now is the time to do it,” said Paul Auslander, certified financial planner and director of financial planning at ProVise Management Group, of tax loss harvesting. “Whenever there is a window, you want to take advantage of it.”
The best way to execute the tax-loss reaping strategy is to balance the losses with the gains, Auslander said. In this way, the earnings of the winners are essentially free.
Natee Meepian/Eyeem | Eye | Getty Images
There are, however, a few caveats.
For one thing, investors shouldn’t sacrifice their overall investment goals to save money on taxes.
They should also check whether their losses and gains are ‘short-term’ or ‘long-term’ (ie whether the investments have been held for less or more than a year). Short-term losses generally only offset gains on short-term investments, even if not always. And using a short-term loss to offset a long-term gain may not be efficient, since long-term profits come with a preferential tax rate.
Investors can also lose the strategy’s tax benefits if they violate the “wash sale” rules.
These anti-abuse rules prohibit investors who sell a losing investment from repurchasing the same or “substantially identical” security within 30 days before or after the sale. Otherwise, the IRS may to refuse the tax benefit.
This means Investors have two choices: they can keep the proceeds of their cash sale for 30 days or use them to purchase an investment that is not “substantially identical”.
The definition of “essentially identical” is somewhat vague. Selling 1,000 Meta shares and immediately buying more Meta shares is a clear no-no. But what about buying other stocks like Snapchat or Microsoft within the 30-day window? The IRS may frown because these are (like Meta) tech stocks, Auslander said.
But the investor can almost certainly buy stock in a company like Boeing without drawing the ire of the IRS, since the companies are not in the same industry category, Auslander said.
Similarly, selling one stock index tracking fund for another (e.g. swapping an S&P 500 fund for a DJIA fund) probably wouldn’t work. But selling a growth-oriented equity fund for one with a value tilt would probably be fine, Auslander said.
And if you’re selling 1,000 shares of a stock or fund, it might make sense to buy a different number of shares (perhaps 900 or 1,100 shares) of the new investment (if in the sell window fictitious 30 days).
However, the best approach in today’s market may be to avoid triggering these rules altogether – by staying in cash for 30 days. Given current market volatility, being out for about a month is unlikely to cost investors much, if any, return, Auslander said.
“Because the definition [of ‘substantially identical’] is a little vague, why put the taxpayer in that position?” he said. “I would make a strong case for sitting in cash and waiting.”