How to Make Lemonade out of Lemons in a Down Market

So far, in 2022, investors are enduring one of the worst starts to the stock market in decades. While stock market downturns are inevitable, there’s no way to predict when they will occur or how long they will last. If there is one consolation for investors anxiously watching their portfolio values decline, you won’t have a loss if you don’t sell your stocks.

Investors with a historical perspective of the market know that every downturn is followed by a more enduring market advance that goes on to new highs. Patient investors can not only reap the rewards of those new highs but also take advantage of opportunities to boost their investment performance while waiting for the market to recover through tax-loss harvesting.

How Does Tax-Loss Harvesting Work?

When used deliberately at opportune times, tax-loss harvesting can be an effective strategy for increasing long-term after-tax returns. At its core, tax-loss harvesting consists of selling a stock for a loss and using the capital loss to offset any gains or income generated throughout the year for immediate tax savings.

The IRS code allows investors to deduct up to $3,000 of capital losses annually against ordinary income. Ordinary income includes capital gains from stock sales. If you have more than $3,000 in losses, you can carry them forward to future years.

If you still want to own the stock you just sold, you can repurchase it after waiting 31 days to avoid the IRS "wash sale" rule. The rule states that if you purchase a stock within 30 days of selling it, it is considered a wash sale which disallows the capital loss deduction. You can wait 31 days and repurchase the same stock, but you risk buying it at a higher price, which might make it a less desirable investment.

Alternatively, you can immediately purchase another stock that is similar but not "substantially identical." For example, you could sell shares of Facebook and immediately replace them with shares of Amazon, which would not be considered substantially identical. Or, you could temporarily replace your Facebook shares with a "proxy" investment, such as a technology ETF, and then sell it after 30 days to repurchase your shares.

How Do Investors Benefit from Tax-Loss Harvesting?

When done in compliance with IRS rules, tax-loss harvesting can provide you with an immediate tax break while allowing you to keep your portfolio intact for the long term. When you eventually sell the stock for a gain, you will be taxed at the more favorable long-term capital gains rate. To that extent, tax-loss harvesting is a tax deferral strategy that can also enhance your portfolio’s long-term performance.

The more you can defer taxes on investments, the better your long-term returns. For example, if, instead of paying the IRS $1,000 in capital gains taxes today, you wait 20 years. Through the power of compounding returns, the difference in value would be substantial. At a compounded rate of return on your investments of 7%, your $1,000 would be worth nearly $4,000 in 20 years. That’s an extra $3,000 you earned on the amount that would have been lost to taxes 20 years earlier.

Beyond tax deferral in your lifetime, you can defer capital gains indefinitely for future generations. Assets passed to your heirs are received on a stepped-up basis at your death, eliminating the capital gains.

Tax-Loss Harvesting as Part of a Sound Investment Strategy

As with any investment strategy, tax-loss harvesting should only be done in the context of your investment objectives. Tax-loss harvesting requires proper timing, a firm grasp of security selection (which to sell and buy), and an understanding of tax implications, so it is essential to work with a financial advisor with experience in portfolio management.