One Action You Can Take During a Market Downturn

One Action You Can Take During a Market Downturn

During times of stress we naturally feel the urge to do something, if only to create the illusion that we have some degree of control over the situation. But after a market meltdown advisors will tell you (correctly) that selling stocks now 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 one action you can take when your investments are in the red. It’s called tax-loss harvesting (TLH).

TLH is a technique used by many advisors to help clients reduce their current taxes. Ordinarily it involves selling investments that are currently at a loss to offset the taxable income from the sale of investments with embedded gains that need to be sold for portfolio rebalancing purposes. It can also be used when all your investments are at a loss. But you have to follow the rules carefully.

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 have 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 one of the reasons selling stock in the middle of a market downturn is a bad strategy is because you have no idea when the market will turn around. If your longer-term goal is to remain invested in HPE, you don’t want to have to repurchase it in the future for more than $20K or you’d end up selling low & buying high. OK, so why not sell the stock and then buy it back the next day? Because then you’d be in violation of the wash-sale rule, which disallows taking a capital loss if the same investment is re-purchased within 30 days of a sale.

Fortunately there is a way to get around this rule. You simply replace the stock you sell with another that has similar expected performance (let’s say IBM in our example). You would get the tax loss benefit plus avoid being left behind in case the stock market should bounce back. And after 31 days you could sell the IBM stock and buy back the HPE if that’s your preference.

Unfortunately stock returns can vary widely over a month, even among companies in the same industry. TLH works best when investing in mutual funds or ETFs. You can sell one fund and immediately replace it with another similar one without violating the wash sale rule. Be careful though when investing in passively-managed funds that track the same index. The IRS could consider them similar enough to violate the wash-sale rule. Selecting a replacement fund that follows a different index or strategy would be prudent.

Because retirement accounts such as IRAs, Roth IRAs, and 401(k)s are already tax-deferred, TLH can only be applied to taxable brokerage accounts. For those, tax-loss harvesting can not only save you taxes during a downturn (when you can really use the money) but also optimize your taxes over the longer term if you implement it properly.

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