Although it can be stressful, stock market volatility can be very beneficial for the savvy investor. Why? Because as investors watch the Dow swing up and down, tax loss harvesting is a good way to make this chaos work for you.
Tax loss harvesting gives investors the opportunity to offset gains they may have made in the previously booming market. It’s typically a strategy to use with taxable accounts — a tax-free IRA or 401(k) simply doesn’t offer the same best opportunities to lower your tax bill as they are already tax advantages.
Tax-loss selling, though, does require a little know-how and some research into the right ways to sell and buy so you don’t violate rules that will reduce the amount you can claim as a loss. First, let’s look at the basics of tax loss harvesting and how investors can best use this strategy.
What is Tax Loss Harvesting?
Simply put, tax loss harvesting is a technique that leverages investment losses to offset some of an investor’s tax burden.
This is common following long bull markets, when gains stack up. For those investors who have realized capital gains from selling during the high points of the market, a tax loss sale once things go south can help offset those gains.
The ideal securities to consider selling for tax loss harvesting are those that are currently trading below your cost basis, or the total you spent for shares plus commissions, dividends that were reinvested and any distributions for capital gains.
Offsetting Capital Gains with Losses
A quick rundown on capital gains: Whenever an investor sells an investment for more than they paid, including commissions, they incur capital gains for that tax year (unlike losses, gains can’t be spread out over multiple tax years).
Over one year and a day, those are long-term capital gains; under that time, it’s considered a short-term capital gain. These gains are taxed slightly differently depending on your income and whether you file as a single taxpayer, head of household or married individual.
When you incur a loss, you can’t take more than a $3,000 deduction each year on your taxes. It is possible under most circumstances to carry additional loss out over subsequent years, that depends on each investor’s individual circumstances, but selling at the right time for a calculated loss and swapping securities is a smart way to reduce the overall tax burden. Losses can carry forward at $3,000 a year or until you have a significant capital gain.
Swapping Securities
Once you’ve identified the stock or fund you wish to sell, it’s time to find the right security to replace it. Buying a similar security ideally allows you to keep your position in the market, but you (or your spouse) can’t snap up the same or nearly identical stock or fund within 30 days.
An IRS regulation known as the wash-sale rule prevents you from then taking the tax loss you’re trying to get. You may, however, move from a mutual fund to an ETF that tracks even slightly different indexes as they are not considered “substantially identical” under these tax rules.
One downside of buying a new security is, well, finding that security.
An investor will want something that will perform well despite the rocky road we’re on. It needs to meet your criteria for market sector, region and risk. That can take a significant amount of time and energy to suss out, so to speak.
First, let’s delve into what tax loss harvesting really looks like in action.
An Example of Tax Loss Harvesting
Let’s suppose that you had purchased $10,000 of the popular SPDR S&P 500 ETF in mid-February of this year, when it was at a high of $337.60. At the close of the day on April 1, 2020, the fund was valued at $246.15.
If you sold on that day, you’d be unloading 29.6 shares that are now worth $7,291, or roughly $2,708 less than what you paid. Quite a tumble, right?
As an investor, you essentially have three choices:
- Hold the fund, hoping it comes back.
- Sell the fund, take your loss and deduct that $2,708 from your taxable income this year. You hold on to the money from the sale or put it into a different type of investment vehicle.
- Sell the security, take a deduction and/or apply the loss to any capital gains and then invest in a different security that continues to maintain a similar balance in your portfolio.
If you want to continue the same market exposure with the least overall financial loss, option 3 — a tax loss harvest — may be your best choice. Remember that you can’t purchase a nearly identical fund, but you can move from an ETF to a mutual fund. You realize $2,708 in losses, which gives you more tax savings or a larger refund. Your investment cash flow stays roughly the same because you have reinvested in another security.
How Magnifi Can Drive Value in Volatile Markets
The trick to successful tax loss harvesting is finding the right related security to invest in — one that won’t negate your tax loss but keeps your position in the market.
With a basic S&P 500 index fund like in the example above, you have multiple options, but if your fund is more specialized or covers a particular market sector, you may have more difficulty finding a comparable but not identical security in which to reinvest your funds.
That’s where Magnifi comes in. With Magnifi’s superior, semantic search driven investment tools, investors can quickly identify investment opportunities in a specific sector.
For example, you can run a search for any term — let’s say, “low risk emerging market funds” or even “funds that do well when markets fall” — and find a list of the relevant funds. Sort results that come up by a number of factors, including return, fees, risk, volume and assets. You can also choose to filter by vehicle, sponsor, asset class or philosophy. Review possible securities organized by regions, sectors and much more until you locate the ideal investment for your available funds. You can also see related searches made by others and themes that may actually be closer to what you’re seeking.
It’s true that the market has been unpredictable and wild recently. Still, there are ways for investors to benefit from the volatility, including taking a tax loss and reinvesting to hold their position in the market.
Best of all, with the research and discovery tools on Magnifi you can accomplish this without time-consuming, tedious research. You’ll get real value through finding the right solution for your bottom line, while the rest of the world just tries to hang on for this wild roller coaster ride.
Magnifi is changing the way we shop for investments, with the world’s first semantic search engine for finance that helps users discover, compare and buy investment products such as ETFs, mutual funds and stocks. Try it for yourself today.
This blog is sponsored by Magnifi. The information and data are as of the publish date unless otherwise noted and subject to change. This material is provided for informational purposes only and should not be construed as individualized investment advice or an offer or solicitation to buy or sell securities tailored to your needs. This information covers investment and market activity, industry or sector trends, or other broad-based economic or market conditions and should not be construed as investment research or advice. Investors are urged to consult with their financial advisors before buying or selling any securities. Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. Past performance is no guarantee of future results. This content may not be reproduced or distributed to any person in whole or in part without the prior written consent of Magnifi. [As a technology company, Magnifi provides access to tools and will be compensated for providing such access. Magnifi does not provide broker-dealer, custodian, investment advice or related investment services.]
