Throughout the year, the markets ebb and flow, rise and fall. Recent years, especially 2022, have been particularly volatile. Market corrections in particular can be unsettling, even scary. But there are strategies to employ that take advantage of volatile markets, including market corrections.
Most people are familiar with the idea of buying into the market when stock prices are low. The markets recover, always have, and if you buy at the lows you stand to reap substantial returns. But down markets, corrections, also offer a tax benefit, one that can deliver significant savings. Through “tax loss harvesting” investors can offset already realized capital gains as well as future gains in nonqualified accounts because the losses carry forward in perpetuity.
How it works
Tax loss harvesting is the process of selling investments at a loss to offset gains and the tax liabilities of non-qualified accounts. Once a position is sold, a similar investment consistent with your investment objectives is purchased for 30 days to fulfill “wash sale” requirements, the period during which you can’t buy back the same stock and claim the tax benefit of the loss without incurring a penalty. At the end of the wash sale period, the investment originally sold is repurchased with the cash from selling the “placeholder” investment.
When to sell
A common misconception is that tax loss harvesting is done at the end of the year, but opportunities present themselves throughout the year. It may be most impactful during a market correction, but if your portfolio is broadly diversified, as it should be in most cases, the opportunities could arise at any time; the losses in one asset class, say commodities, could offset gains in another, say, utilities.
This gets back to having a strategic approach to managing investments and why your financial advisor, the investment expert, and your CPA, the tax expert, should work in lockstep to help you reach your goals.
Drawbacks
While tax loss harvesting can be broadly applied, there are some considerations—and some drawbacks. The strategy does not work for qualified accounts, like your 401k or your IRA. Taxation only occurs when distributions are made and will use your ordinary income rate, not capital gains rates.
A more subtle consideration is that the cost basis of the investment you’re selling is reset upon repurchasing the security. If that cost is lower than what you originally paid for the stock, it could produce a greater realized gain when you sell in the future, if not properly managed. As well, if the market rebounds and the placeholder funds increase dramatically during the 30-day wash sale period, you might need to hold the position for a least a full year to avoid a short-term capital gain, which is taxed at your income tax rate, not the capital gains rate.
Tax loss harvesting is one aspect of a strategic approach to managing an investment portfolio. It might be most beneficial for investors who have already realized significant gains in a given year and are looking to avoid a large tax bill come the following April, but it can generate substantial savings in most portfolios. It is a powerful tool for financial advisors and their clients. It should be a part of regular conversations with your financial advisor and CPA, another key strategy to employ in helping you reach your long-term financial goals and objectives.
IMPORTANT DISCLOSURES
The information included in this document is for general, informational purposes only. It does not contain any investment advice and does not address any individual facts and circumstances. As such, it cannot be relied on as providing any investment advice. If you would like investment advice regarding your specific facts and circumstances, please contact a qualified financial advisor.
Any investment involves some degree of risk, and different types of investments involve varying degrees of risk, including loss of principal. It should not be assumed that future performance of any specific investment, strategy or allocation (including those recommended by HBKS® Wealth Advisors) will be profitable or equal the corresponding indicated or intended results or performance level(s). Past performance of any security, indices, strategy or allocation may not be indicative of future results.
The historical and current information as to rules, laws, guidelines or benefits contained in this document is a summary of information obtained from or prepared by other sources. It has not been independently verified, but was obtained from sources believed to be reliable. HBKS® Wealth Advisors does not guarantee the accuracy of this information and does not assume liability for any errors in information obtained from or prepared by these other sources.
HBKS® Wealth Advisors is not a legal or accounting firm, and does not render legal, accounting or tax advice. You should contact an attorney or CPA if you wish to receive legal, accounting or tax advice.
