Bonds have taken a beating in 2022, but the damage to your portfolio may be less than meets that eye, provided you handle those losses in a tax-smart way. That’s because a technique more commonly associated with equities can ease the pain of this year’s fixed-income losses. That technique is tax-loss harvesting, although when applied to bonds there are some key differences from the way the process is used with stock losses. Here’s what you need to know.
A financial advisor can help you adjust your financial plan to deal with investment losses in bonds and other assets.
Tax-Loss Harvesting Defined
Tax-loss harvesting is a way of using your investment losses to lower your taxes on capital gains. Basically, it shows the IRS that while you made money from some investments, you lost money from others. Therefore, you don’t owe as much in taxes. The process of tax-loss investing involves selling assets at a loss and buying similar investments. It allows you to take advantage of your losses for tax purposes and maintain your desired asset allocation.
Wondering why you have to sell an investment in order to realize a loss? Consider what it’s like to buy a new car. Its value depreciates as soon as you leave the lot, but you won’t realize the loss or see it impact your wallet until you try to sell the car. Similarly, you may know that your assets are underperforming, but you can’t claim your losses until you sell your investments.
You can harvest your bond losses for any or all of three reasons:
- Offset realized gains elsewhere in your portfolio for this tax year
- If you have leftover losses, you can reduce your taxable income by up to $3,000
- Carry the loss forward into another tax year and use it in the future
Why Now May Be the Time to Harvest Bond Losses
Bond losses on the scale currently being experienced make tax-loss harvesting of fixed-income assets appealing, according to Charles Schwab.
The first nine months of this year are the worst for bonds since 1926. All major fixed-income indexes fell in 2022, and some types of bonds fell particularly hard. The Bloomberg U.S. Aggregate 10+ Year Index has tumbled 29.5% as of the end of November, and corporate credits bonds have dropped 17.6%. Other double-digit losers include municipal bonds, high-yield bonds, preferred securities, securitized bonds and Treasury bonds.
Consider the hypothetical case of someone in the 37% tax bracket. Over a year ago, this person bought intermediate-term municipal bond mutual fund shares. Due to the drop in the market, the value of that mutual fund today is $9,000. This person, perhaps working with a financial advisor, could sell the mutual fund for a $1,000 loss and use that loss to save on his or her tax liability, according to Charles Schwab. If the person used the $1,000 loss to offset other short-term capital gains, the person could potentially save $370 on his or her tax bill, in other words, cutting the $1,000 loss down to $630.
The Wash-Sale Rule
The wash-sale rule is an IRS rule that aims to keep investors from snagging tax breaks unfairly. The rule says that investors cannot gain the short-term benefit of selling a security at a loss and then buy a substantially identical security within the next 30 days. The “substantially identical” part of the rule is what often trips investors up. IRS Publication 550, which covers capital gains and losses, doesn’t offer a strict definition of what’s falls under this description. Rather, it states the following: “Ordinarily, stocks or securities of one corporation aren’t considered substantially identical to stocks or securities of another corporation. However, they may be substantially identical in some cases.”
Charles Schwab adds that you can’t avoid the wash-sale rule by selling a security at a loss in one account and repurchasing it within the 30-day window in another account: “Nor can you avoid it by having your spouse or a corporation you control purchase the same or substantially identical security. The IRS considers the totality of your trades, not just on an account-by-account basis.”
How to Decide Which Bonds to Sell
Here are some criteria for deciding which bonds to sell:
- Bonds that have lost value. Consider the value of your securities relative to your cost basis, not your original investment.
- Bonds with a shorter duration. Tax-loss harvesting can be an opportunity to better position your portfolio for the current market environment. Charles Schwab says the bulk of the move up in interest rates is likely behind us and that investors should extend the average duration of their bond holdings to take advantage of the recent move up.
- Bonds with a lower credit rating. The opportunity to sell lower-rated bonds at a loss opens up the opportunity to move up in credit quality.
Fixed-income securities have been hammered in 2022. That opens the opportunity for tax-loss harvesting to reduce the losses and improve your investment portfolio’s prospect for stronger future gains. Just remember that tax-loss harvesting for bonds is somewhat different from tax-loss harvesting of equity losses. If you’re not sure whether your bond losses are candidates for tax-loss harvesting consult a financial advisor or tax attorney.
Tax Tips Tips for Investments
- A financial advisor can help you decide how best to handle losses in the fixed-income securities of your portfolio. SmartAsset’s free tool matches you with up to three 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.
- Use our no-cost income tax calculator to see how much you will owe the federal government.
Photo credit: ©iStock.com/PashaIgnatov, ©iStock.com/SIphotography, ©iStock.com/chingyunsong