Tax Strategy for Market Volatility

As the market volatility ramps up with the election around the corner so much is beyond our control (stock prices, volatility, interest rates, etc.), but we can take advantage of market movements to improve our bottom line. Tax-loss harvesting is one such opportunity. Tax-loss harvesting refers to selling stock at a loss to offset capital gains.

Tax-Loss Harvesting

Under the current tax law, up to $3,000 of capital losses in excess of capital gains can be claimed annually, and any excess capital losses can potentially be carried forward to offset capital gains in future years.¹ But remember, tax rules are constantly changing, and there is no guarantee that the treatment of capital gains and losses will remain the same in future years.

Tax Savings

If you sell all or part of a position in your taxable account when it is worth less than you paid for it, this generates a realized capital loss. You can use that loss to offset capital gains and other income in the year you realize it, or you can carry it forward into future years.² A tax professional should be consulted to avoid the IRS’s “wash-sale rule.” This rule provides that investors can’t claim a loss on a security if they buy the same or a “substantially identical” security within 30 days before or after the sale.¹

Strategic Goals

When harvesting a loss, it’s imperative that you remain true to your strategic investment plan as this is the most important factors in achieving your financial goals. To prevent a tax-loss harvest from skewing your portfolio out of balance, we reinvest the proceeds of any tax-loss harvest sale into a similar position (but not one that is “substantially identical,” as defined by the IRS).

The Tax-Loss Harvest Round Trip

The goal is to have generated a substantive capital loss to report on your tax returns, without dramatically altering your market positions during or after the event. Here’s a three-step summary of the round trip typically involved:

Sell all or part of a position in your portfolio when it is worth less than you paid for it.
Reinvest the proceeds in a similar (not “substantially identical”) position.
Return the proceeds to the original position no sooner than 31 days later.

Practical Caveats

An effective tax-loss harvest can contribute to your net worth by lowering your tax bill. That’s why we watch for potential harvesting opportunities all year and not just at year end. That said, there are several reasons that not every loss should be harvested. Here are a few of the most common constraints to bear in mind.

Trading costs

The tax-loss should generate more than enough tax savings to offset the trading costs involved. As described above, a typical tax-loss harvest calls for four trades: There’s one trade to sell the original holding and another to reinvest in the market during the waiting period. Finally, there are two more trades to sell the interim holding and buy back the original position.

Market volatility

When the time comes to sell the interim holding and repurchase your original position, you ideally want to sell it for no more than it cost, otherwise it will generate a short-term taxable gain that can negate the benefits of the harvest. We may be forced to hold the new asset to avoid initiating a tax gain in highly volatile markets.

Asset location

Holdings in your tax-sheltered accounts (such as your IRA) don’t generate taxable gains or realized losses when sold, so we can only harvest losses from assets held in your taxable accounts.

It’s never fun to endure market downturns, but market volatility is an intrinsic part of investing. Tax-loss harvesting is the equivalent of turning your financial lemons into lemonade by converting market downturns into tangible tax savings. A successful strategy lowers your tax bill, without substantially changing your long-term investment outcomes.