Tax-Loss Harvesting: How to Use the Market Downturn to Save on Taxes This Year

J.D. is on vacation. This is a guest post from Linden Cornett. Linden is a Portland-area professional with an interest in finance.

The stock market is down this year, and many people have asked me if I've made any changes to my investments as a result. My general strategy is to buy-hold-rebalance my stock and bond investments, so I've mainly used this downturn as an opportunity to buy stocks at bargain prices.

There is one tax strategy that I'd recommend to anyone who has losses in a taxable account. I've already done this with a few of my investments, and maybe you should too. The strategy is known as “tax-loss harvesting”, and here's how it works.

Tax-loss harvesting
Suppose you have an investment with a cost basis of $10,000, and its current value is $5000 (certainly possible given the stock market's performance this year). Let's assume that in two years from now, the value of your investment would return to $10,000. If you do nothing, you'll have a $10K investment in 2010 and owe no taxes if you were to choose to sell it at that time.

If, instead, you sell your investment this month, wait 31 days, and then buy it back, you'll be able to realize the $5000 loss on your 2008 tax return.

During those 31 days, you might choose to invest in a money market fund or some similar investment so that you don't miss out on a possible upswing in the market during that 31-day period — more on that later. Assuming no significant market movements during the 31 days, you'll still have a $5000 investment. In this case, what have you gained?

Offsetting capital gains
First, the $5000 loss on this year's tax return can be used to offset any other capital gains you might have realized this year. If you don't have any capital gains this year, then you can use the first $3000 worth of losses to avoid paying taxes on current-year income. Any amount over $3000 can be carried forward as capital losses towards your tax returns in future years. The losses can be carried forward indefinitely and used to offset $3k of income each year or to offset future capital gains.

But what about your investment, which used to have a cost basis of $10,000 and now has a cost basis of $5000? When you sell this investment at some point in the future, won't it be a wash since you'll have to pay taxes on an extra $5000 of investment gains? Although future tax rates are an unknown, we are making two assumptions here:

  • The first is that capital gains tax rates will continue to be lower than income tax rates.
  • The second is that we'd prefer to defer paying taxes (after all, isn't this why we invest in 401(k) plans?).

Current capital gains tax rates are 0% for those people in the 10% and 15% income tax brackets. For people in the 25% and higher income tax brackets, capital gains are taxed at 15%.

If a person in the 25% tax bracket takes a capital loss of $5K this year, she can reduce this year's taxable income by $3000 and next year's taxable income by $2000. Disregarding state taxes for a moment, she would save $750 this year and $500 next year on federal taxes, for a total savings of $1250.

If she decides to sell her investment with a long-term gain of $5000 in 2010, she will pay $750 in capital gains taxes, for a net savings of $500. If she waits until retirement to sell the investment, which may be decades away, the current savings of $1250 may be compounded over a long period of time.

The waiting game
What should you do with your investments during the 31-day period before you can buy them back? One option is to simply let your cash sit in a money market fund. It will earn a guaranteed interest rate and will be safe from losses. The downside to this choice is that you may miss out on an upswing in the market. With the current levels of volatility in the market, bad timing could mean you'll miss a significant rally.

Another option is to temporarily invest your money in a similar investment. For example, if your money is currently in the Vanguard Total Stock Market Index (VTSMX), you could swap over to the Vanguard 500 Index (VFINX) for 31 days, and then swap back. This way, you'll still earn the same approximate market return that you would have earned had you done nothing.

The downside to this choice is that you may lose money during the 31-day period. Also, if the market does go up, you'll have a short-term gain, and you'll have to pay taxes on that gain.

Each investor needs to decide for herself which option makes sense for her particular situation and temperament. You may also choose to use this opportunity to change your portfolio if your current investments are not the ones you'd like to hold for the long term.

Playing by the rules
To make sure that your tax-loss harvesting meets IRS requirements, you must refrain from buying any shares of your investment, or a “substantially identical security”, for the 30 days before and the 30 days after selling it at a loss. This is known as the “wash-sale rule”, and it is the reason for waiting 31 days after selling your investment before buying it back. Make sure that you have not purchased any shares of the investment during the 30 days prior to selling as well.

A “substantially identical security” is a little bit of a grey area. It is certainly not allowed to sell shares of a particular stock and then buy back the same stock within the wash-sale time period. Selling shares of one S&P 500 fund and buying a different S&P 500 fund for 31 days is unlikely to cause an issue, but you're probably better off swapping into funds with somewhat different holdings.

Not for everyone
For people in higher tax brackets, or with larger losses, the benefit increases, although it may take many years to whittle away at the carried-forward loss at a rate of $3000 per year.

For some people, this strategy may not make sense.

  • For example, if you only have small losses, it is probably not worth the effort since this strategy does require a bit of work. It's probably only worth it if the losses are a significant dollar amount to you (each person has a different definition of “significant”).
  • Also, if you would have to pay fees and/or commissions in order to buy and sell, it may not be worth making any changes (this is yet another reason to invest in no-load mutual funds).
  • Finally, if you are in a low tax bracket now, but expect to be in a higher tax bracket in retirement, the benefit decreases or vanishes.

This has been a brutal year for stock and bond investors. Many of my friends and family have called me in a panic asking if now is the time to abandon the stock market. My advice to stick with their investment plan is not always what they'd like to hear, so it is helpful to be able to recommend tax-loss harvesting as a concrete way to benefit from capital losses.

In addition, there is a psychological benefit to doing something, and this is a more beneficial tactic than changing your investment plan as an emotional reaction to a disappointing year.

Photo by Linden Baum.

More about...Investing, Taxes

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Writer's Coin
Writer's Coin
11 years ago

I would echo the “not for everyone” statement. For most people, simple things like asset allocation are tough enough to follow. This is more of an advanced move for those that know what they’re doing.

But you describe the wash/sale rule very clearly.

JGR
JGR
11 years ago

Great article! I would suggest for those in a situation similiar to the VFINX/VTSMX situation, that you hold onto the fund that you are newly entering into for more than the 31 days. These funds have historically performed very similiarly, and would avoid a near-term capital gain tax if the market does go up in the 31 days.

jim
jim
11 years ago

If you opt to harvest your losses, you’ll always want to find a similar investment for that 31 day period because otherwise you’d sitting on the sidelines while your investment may appreciate. While there’s the risk it could depreciate, you would’ve had that risk if you held your position. Putting it into a money market wouldn’t be helpful at all.

Stop Buying Houses
Stop Buying Houses
11 years ago

Very detailed. Thanks. One thing that people are going to have a hard time with is knowing what is discounted and what is hanging on by a thread. Deep discounts don’t mean great deals. Lots of people get into trouble this way. You need to know where the bottom is but that’s not easy to do. Now is the time to really spend time to take a closer look at potential investments. Really dig deep into the company and their market and figure out where the stock might head. During good times, people can just throw darts to create their… Read more »

Chris
Chris
11 years ago

A very important concept for any investor to understand. Knowing this technique can help keep you from hanging on to losers for too long and avoid the disposition effect.

Aman
Aman
11 years ago

Many people forget about the importance of the wash-sale rule. Glad you pointed that out in your detailed post!

Gwendally
Gwendally
11 years ago

Two comments: The strategy of harvesting losses to offset gains is not for single people with an AGI of under $41,000 or for married filing jointly of under $82,000, as their gains will be taxed at 0% this year. It’s foolish to offset them at that rate! Also, beware capital gains distributions this year. They’re going to be bigger than ever for a lot of people and they may not even see them coming. Mutual funds had to liquidate a lot of long-term holdings to cash out people this year and we’re going to be stuck with the incomprehensible reality… Read more »

katy
katy
11 years ago

..Finally, if you are in a low tax bracket now, but expect to be in a higher tax bracket in retirement, the benefit decreases or vanishes…

thank you!

Jeff
Jeff
11 years ago

Wow, you just blew my mind. Lots to think about now. Is this method always done in December for some reason?

dale
dale
11 years ago

Well done and very timely topic. I just completed a sale last week that will allow me to show a $3K loss for 2008 tax year. I full intend to repurchase the shares next month.

Bill M
Bill M
11 years ago

Yes Indeed, This is a great time to sell, take the loss now if you need it and buy again next month.

Jason Moran
Jason Moran
11 years ago

What investments does this apply to? Is it only stocks? Is there any way to finagle this maneuver with a 401k, IRA, or other retirement vehicles?

John Egan
John Egan
11 years ago

Great article… Also suggest using this strategy and time to move away from Mutual Funds and into ETFs, particularly if you use index funds…. You not only can save considerably on fees, but you can also apply stop-losses which are harder to do on Funds.

Also, don;t forget “Sell your Funds on an up day!” .. Presuming we actually have one before year end…

Merry Xmas! jegan 😉

Anon
Anon
11 years ago

Great post. A couple of notes: 1. To further minimize the current tax bite, sell mutual funds before the December dividend has been paid, and buy mutual funds after the December dividend has been paid. Same goes for ETFs. 2. There’s another advantage of the $3,000 carry over that sometimes goes unnoticed – the $3,000 loss taken against regular income is taken on page 1 of your 1040 – which reduces your AGI. This can be advantageous because a high AGI is used to reduce personal exemptions and itemized deductions, and is also used to determine whether you are subject… Read more »

Anon
Anon
11 years ago

@ Jason post #12 – this can only be used for investments in taxable accounts – stocks, bonds, mututal funds, ETFs. It cannot be used in 401Ks or IRAs

TosaJen
TosaJen
11 years ago

Wow — perfect timing with a well-written article about this subject. Nice — thanks!

Turns out, we’re trying to figure out how to move money most painlessly from taxable investment accounts to fund our IRAs. This information gives us more info to consider.

mwarden
mwarden
11 years ago

At first I was glad to see this topic covered on this site. It is definitely an advanced topic, and I do hope that the majority here got something out of it. BUT, I’m not happy that this is portrayed as a way to “offset” capital gains. If you play by the IRS rules, you are only DEFERRING capital gains taxes, not offsetting them. For example, let’s say you have losses of $10,000 in SPY and you sell it now to capture that loss. For this tax year, you use those losses to offset $10,000 in gains from the sale… Read more »

mwarden
mwarden
11 years ago

I guess there is some mention of deferral at the beginning, but it is not explained why this is a deferral rather than an offset. Hopefully my comment above adds to that explanation.

Nick
Nick
11 years ago

Just be careful in regards to which investments you do this with. Some that are more volatile might turn around in the 30 days time you are waiting to re-attain the item, and then all will be for naught.

Lars
Lars
11 years ago

Nice. Just reading this article just saved me over a grand, if I don’t mess up the transactions in my account.

andy
andy
11 years ago

Given 2008, most investors should be able to claim or leverage the $3000 capital deduction. If you use it, it’s like a 33% return for those in the top tax bracket. A no brainer.

Jeff
Jeff
11 years ago

Well written article, and timely. One point is in order on the wash sale rule. The article is accurate that “substantially identical” is a big grey area on the wash sale rule. However, I disagree with this quote: “Selling shares of one S&P 500 fund and buying a different S&P 500 fund for 31 days is unlikely to cause an issue” I wouldn’t be so sure. As a tax lawyer that represents clients before the IRS, that’s not a position I’d like to defend. There is a substantial risk the funds would be considered substantially identical since they track the… Read more »

One Million Bucks!
One Million Bucks!
11 years ago

Very nice article. Goes through the full array of items. If you’d like to see a few more examples you can do here if you like…

http://www.onemillionbucks.net/2008/10/tax-loss-carryforwards-huge-tax-savings.html

It also carry’s a link directly to the IRS Publication 15 which goes into more depth on the subject.

Get Rich Slowly Rules!

No Debt Plan
No Debt Plan
11 years ago

It would probably be best to put the money into an ETF rather than a similar mutual fund. Many funds have redemption fees if you redeem within a certain time period (60, 120, 180 days).

PB from One Million Bucks!
PB from One Million Bucks!
11 years ago

Very good point. I would even add to that by saying you will probably save on transaction costs, as mutual fund trading costs tend to be higher then ETF’s ($20 at Etrade for mutual funds).

Thanks!

-PB @ OMB!

SJOLZ
SJOLZ
11 years ago

Anyone know if there is a cutoff date for making trades applicable to 2008 taxes? Can I sell my losses in February 2009 and count these losses toward 2008 taxes? Presumably, trades for my 2009 taxes would then start wherever I chose the cutoff for trades for my 2008 taxes.

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