If you’re one of the more than 24 million new investors who’ve jumped into stocks since 2016, you’ve never seen a down market except for 2018, when stocks were off a mere 6%. For this year, stocks are off more than 17% – so far – slapping investors with a nasty loss that isn’t likely to get much better between now and New Year’s Eve.
What’s a smart investor to do? Sell.
While it seems like the exact wrong move to deliberately lock in a loss instead of waiting for share prices to recover, there’s one very good reason: taxes. Thanks to a technique called tax-loss harvesting, an investor can use the hit they take by selling losing shares to offset taxes on profits from other investments that show gains. And even if you don’t have any stock profits to offset, the loss can be used to reduce your personal income tax bill.
This strategy isn’t new, but investors who’ve been in the market for just a few years haven’t seen a significant down year where they’d have enough of a loss to make it work. It’s perfectly legal and approved by the IRS, but it applies only to taxable investment accounts, not Individual Retirement Accounts, 401(k)s and other tax-deferred accounts.
For assistance with tax-loss harvesting to reduce your tax liabilities, consider matching with a vetted financial advisor for free.
How Does Tax-Loss Harvesting Work?
Here’s how it works:
- Let’s say you were smart or lucky enough to buy 1,000 shares of the iShares MSCI Brazil ETF (EWZ) in early January. The share price was up about $4 per share for the year by early December, leaving you to face taxes on this $4,000 gain that could cost you as much as $1,480 at the top capital gains tax rate of 37%. You would much rather prefer to hang on to this profit and keep it invested.
- You also bought shares of the Vanguard S&P 500 ETF (VOO) in early January. The share price was down by about $63 a share at the beginning of December. If you sell 64 shares, you’ll be down a little more than $4,000, producing a loss that offsets your gains on the Brazil ETF.
- But that loss isn’t permanent, because you use the proceeds from the sale of your S&P 500 ETF to buy new shares of that fund or shares of anything you want. If the stock market holds true to history, those shares will produce gains in the future.
- In the meantime, you’ve hung on to the $1,480 you have paid in taxes which, if that money is invested, also will be generating eventual positive returns.
(The gain or loss depends on your cost basis, which is the price you originally paid for each individual share. Subtract that amount from the price when you sell to get your taxable gain or loss. Your capital gains tax rate depends on your income and how long you’ve held the shares sold.)
If you’ve also got a big 2020 income tax bill from other types of income that you’d like to reduce or even eliminate, you could sell additional shares where you have a loss to reducing your taxable income.
Structuring a tax-loss strategy can be complicated, so investors should consult with a tax professional on the details and timing.
Don’t let market losses get you down; tax-loss harvesting can help you lower your tax liability. Those who make a profit from selling investments can lower their tax bills associated with those gains by selling investments on which they’ve lost money. Tax-loss harvesting, and it can be an especially effective strategy for lowering your tax liability and preserving a larger percentage of your investment gains.
Tips for Investors
- If you’re struggling to keep up with your tax planning you may want to enlist the help of a professional. A financial advisor can help you create a financial plan, manage assets and make decisions with taxes in mind. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- You can best create a plan if you know about what you’ll end up owing beforehand. Using SmartAsset’s income tax calculator can help you estimate what you may owe in taxes so you can plan ahead and lower your total liability.
Photo credit: ©iStock.com/mesh Negi