Here’s some consolation for anyone who’s suffered losses in the stock market this year: The rumble in your portfolio may yield some benefits next tax season.
It’s a strategy called “tax-loss harvesting,” and as year-end tax planning approaches, financial experts say this reckless-sounding strategy doesn’t have to be reserved for the rich.
“Anyone who is a taxpayer and has investment dollars potentially has an opportunity to take advantage of this, especially in a volatile market,” said Jonah Gruda, tax partner in the family wealth services group at Marcum, a national accounting and advisory firm.
The term “tax-loss harvesting” sounds daunting to some, said Frank Newman, portfolio manager at Ally Invest, the brokerage arm of Ally Financial ALLY.
“‘Anyone who is a taxpayer and has investment dollars potentially has an opportunity to take advantage of this, especially in a volatile market.’“
But people should not fear the tax trick of accumulating capital losses to offset gains and reduce taxable income, he said. “It’s a great strategy for everyone, regardless of account size,” Newman said.
Selling at a loss seems easy enough in this market. Even with a strong October, the Dow Jones Industrial Average DJIA,
Year to date is down about 12%. S&P 500 SPX,
Off more than 19% and the Nasdaq Composite COMP,
Over 29% are closed.
To use the benefits of tax-loss harvesting, investors need to choose investments for losses and choose when to take those losses (and not to return to the same position too soon due to tax rules). That sounds like an attempt to time the market — a practice many investment experts say people should avoid when working to achieve their long-term goals.
Gruda said there is a tax and investment aspect to the strategy. “A lot of the time, those two goals don’t align seamlessly.”
That said, people shouldn’t let the “tax tail” wag the dog when it comes to investing (and the same goes for making big purchases based on tax incentives, such as electric vehicles and energy-efficient home improvements).
But the market may encourage many people to consider the idea of getting something good out of a capital loss. Here’s a look at some of the finer points of the topic:
Learn the basics
Start with the tax rules on capital assets. It includes stocks, bonds, a portion of exchange traded funds, a portion of cryptocurrency BTCUSD,
and more.
Sell at a profit and capital gains apply to the difference between the initial basis cost to the owner and the sale. For many, the tax rate on long-term capital gains will be 15%, meaning the owner held onto it for at least a year before disposing of it.
This year the 15% rate applies to individuals earning between $41,676 and $459,750, and for married couples filing jointly, it’s $83,351 to $517,200.
Short-term capital gains are bought and sold within a year, so the IRS views the income as ordinary income that is combined with other earnings. He is then taxed in whatever tax bracket he lands in.
Sell at a loss and capital loss applies to the difference between the acquisition price and the sale price. Loss offset gains and then additional losses of up to $3,000 can be deducted against income. Remaining losses are carried forward to future years.
According to Fidelity Investments, short-term losses are applied against short-term gains first, and long-term losses offset long-term gains before long-term losses. After one type of benefit is completely voided, the remaining loss amount can be applied against another type of benefit, Fidelity said.
For this reason, it is important to start by looking at where short-term losses can offset short-term gains, which would be subject to a higher tax rate.
There is another starting point, Gruda said. How much would the potential tax benefit this year outweigh the investment benefit of holding the investment and abandoning the strategy?
There is no blanket answer, he said. In some cases it may be a very low return. In others, it can be a great move. If a taxpayer makes a bet they will have a large capital gain during 2023 or beyond, carry-forwards can be a useful tool in deploying losses.
However, Uncle Sam is ultimately getting a cut of the gains from appreciating assets. Tax loss harvesting “minimizes and defers the tax bill. It does not remove the tax liability on the road,” Gruda said.
Don’t get bogged down by wash sales
Even if a person sells at a loss from their brokerage account or IRA, they still don’t want to exit the portfolio position permanently. They may want to return to the investment at a cheaper price with room for growth again.
As per the IRS “wash-sale” rule, wait a while.
The IRS will not calculate a capital loss if, within 30 days of the sale or within 30 days thereafter, the taxpayer also purchases or acquires a “generally similar” investment. This rule applies to investments such as stocks, bonds, mutual funds, exchange traded funds and options – but not cryptocurrencies.
Gruda said the basic trick is to just keep track of the days. He has seen his share of people who have missed out on tax benefits “because they weren’t watching the clock.”
Another skill is to consider what is considered “substantially similar” to a fast-moving investor who sees a buying opportunity 30 days before or after the day of the sale.
An investor can sell the stock and buy an exchange-traded fund or mutual fund that holds the stock and not run afoul of the rule, Gruda said. Going the other way, buying the stock directly from a mutual fund or ETF that owns the stock won’t trigger the rule, he noted.
Suppose an investor has several investment accounts – perhaps one is a long-term account and another is more for short-term trading. This rule applies to all accounts, Newman noted. So if one sells and the other buys within 30 days before or after, the wash-sale rule will eliminate the capital loss, Newman said.
Buying and selling shares of two different funds that track the same index within a 30-day period can also trigger the wash sale rule, Newman said. However, according to Charles Schwab SCHW’s tutorial, it would be wise to sell a piece of an ETF that tracks the S&P 500 and then shortly thereafter buy an ETF that tracks the Russell 1000 Index.
“It will preserve your tax break and keep you in the market with roughly the same asset allocation,” said one explainer.
But when someone keeps an eye on repurchases and lets the wash-sale window close in one place, they may have an opportunity to start the tax strategy process in a different part of their portfolio. “There are really tax loss harvesting opportunities in different asset classes this year,” Newman said.
