The experts are saying the COVID-19 spread may peak over the next 7-10 days. That could mean the market turns even lower. If that happens, make sure you’re tax loss harvesting. It’s the third leg of the stool when markets tank.
We already covered the first two:
The third one only works for money that’s in a regular brokerage (i.e. NOT your IRA or 401k). It’s an easy way to save a bunch in taxes down the road.
How your investments are taxed
In regular brokerage accounts, we pay taxes along the way. We pay taxes on the dividends. And we pay taxes on capital gains when we sell an investment for a profit.
For example: We invest $1,000 in XYZ and then sell it a year later for $1,100. We made a $100. But after paying Uncle Sam his 15% capital gains tax, we’re left with $85.
When you sell an investment for a loss
If we sell an investment for a loss, we get a tax break. The loss will offset our gains.
For example: We invest $1,000 in ABC. A year later we sell it for $900 – a $100 loss. The $100 loss will offset the $100 gain (from selling XYZ above). Our net gain/loss is $0 and we don’t owe Uncle Sam any capital gains tax.
Tax loss harvesting during market downturns
Here comes the magic sauce. Ready? Tax losses never expire.
Back to the example, let’s say we sold ABC for a $100 loss, but did NOT sell XYZ. That means we don’t have a gain to offset.
But that tax loss isn’t use-it-or-lose-it. We’ll keep it until we have a gain to offset, whether that’s next year, the year after or in 10 years.
So it make sense to collect – or harvest – tax losses when we have them. We turn temporary paper losses in actual losses and wait for the day we have gains to offset.
But what about staying invested?
We know market downturns are temporary, so we don’t just sell our investments, harvest the tax losses and sit on a wad of cash.
Instead, we reinvest that money in a similar – but different – investment. That gives us the best of both worlds. We get to keep our tax loss for a rainy day, but we’ll also be invested when the market snaps back.
The Wash Sale Rule
Uncle Sam is smart. He doesn’t want us to sell ABC, harvest the tax loss, and then buy ABC right back again.
So he came up with the wash sale rule, The Wash Sale Rule says if we buy back ABC within 30 days of selling it, he won’t let us use our tax loss. It will be “disallowed.”
Tax loss harvesting to avoid the wash sale rule
If we sold red delicious apples and harvested a tax loss, we can’t buy back red delicious apples for 30 days. That’d be a wash sale.
But we CAN buy Granny Smith apples instead. They’re apples, but a different kind. So when the market for apples rebounds, we’ll reap the rewards, but also get to keep our tax loss.
With investments that means we harvest our tax loss by selling our large-cap ETF at Schwab and buy the large-cap growth ETF at Vanguard. Or you sell Google and buy Facebook. Or you sell Delta and buy Southwest.
Tax loss harvesting with Betterment and Wealthfront?
I’ve been carefully watching how Betterment and Wealthfront harvest tax losses through this market downturn. And I give them a solid “D+”.
They definitely do not do what they say they do which is harvest tax losses daily.
This is the first major downturn since they became popular, so maybe they’ll learn from their mistakes, but if you’re using them or any other robo-advisor, double check their work. You’re probably missing out.
In Summary
- Tax losses offset capital gains and they never expire
- Harvest tax losses by selling during market downturns and reinvest immediately in a different, but similar investment
- Point your finger at Uncle Sam and laugh
Market downturns already suck, but they’re usually also accompanied by some drastic news story. Instead of joining the hand-wringing herd, let’s find the silver lining knowing brighter days are ahead and find a way – like tax loss harvesting – to make things even better than they were before.
P.S. The Financial Zen Group harvests tax losses on a weekly basis, ensuring you get most – if not all – of the available tax losses.
