Something You Can Do During a Bear Market
During times of stress we naturally feel the urge to take some kind of action, if only to create the illusion that we have some degree of control over the situation. But advisors are saying (correctly) that market timing is unpredictable and that selling stocks during the current market meltdown would achieve nothing except to lock-in losses. So doing nothing, especially if you are investing for the long haul, is the best response. I’m sure this is causing many investors to feel a sense of helplessness. As it turns out, there is something you can do when your investments are in the red. It’s called tax-loss harvesting.
Tax-loss harvesting is a technique used by many advisors to help clients reduce their current taxes. But it’s not as simple as just selling investments whose value has dropped. Here’s how it works. Let’s say you purchased $30K worth of HP Enterprise stock in mid-2019 that’s worth only $20K today. If you sell it, you’ll incur a tax loss of $10K that you can use to offset any other capital gains from other investments in 2020. If you have no other gains this year, you’ll get to reduce your taxable income by $3K (the maximum allowable annual capital loss). And you’ll still have a $7K capital loss carryover that can be used to offset any capital gains in future years.
Remember, though, that selling stock in the middle of a market downturn is a bad strategy, since you have no idea when the market will turn around. Presuming that you normally would have remained invested in HPE, you don’t want to have to buy it back some time later for more than $20K or you’d be buying high & selling low. You could buy it back the day after you sell it, assuming stock market volatility has settled down from the wild swings we’ve been seeing recently. But then you’d be in violation of the IRS wash sale rule, which disallows taking a capital loss if the same investment is re-purchased within 30 days of a sale.
Is there a way to get around this rule? Yes. You simply replace the stock you sell with another that has similar expected performance (perhaps IBM in our example). You would keep the tax loss benefit from the sale of HPE plus avoid being left behind in case the stock market should bounce back. If you prefer to hold HPE rather than IBM for the long term you could sell the IBM stock and buy back the HPE after 31 days.
It’s even easier when you are invested in mutual funds or ETFs rather than in individual stocks. You can sell one fund and immediately replace it with a similar but different one without violating the wash sale rule. However the IRS might consider passively-managed funds that track the same index to be similar enough to violate the rule. This is a gray area so selecting a replacement fund that follows a different index or strategy would be prudent.
In summary, tax-loss harvesting is a strategy to reduce current taxes while remaining invested and deferring future taxes on gains to a time when tax rates potentially could be lower (such as after you’re retired). Unfortunately, because retirement accounts such as IRAs, Roth IRAs, and 401(k)s are already tax-deferred, this technique is only useful for taxable brokerage accounts. Although tax-loss harvesting will not stem losses during a market downturn, it will enable you to reduce your taxes, indirectly putting more money in your pocket at a time when that could be much appreciated!