🔄 From downturns to upturns: tax loss harvesting in today’s market

☕ Good morning!

The market just took a wild ride, and if you're feeling queasy, you're not alone. 

The S&P 500 saw its most significant single-day drop since 2022, while the Dow plunged over 1,000 points, and the Nasdaq 100 erased nearly $1 billion in market value. 

The VIX, aka Wall Street’s Fear Gauge, spiked to levels last seen during the 2008 Financial Crisis and the 2020 pandemic.

Our last newsletter on tax loss harvesting, published in March, explored the fundamentals of tax loss harvesting as a broad strategy to reduce taxable income. 

Today, we’re considering tax loss harvesting as a reactionary technique that can help make any downturn seem like a silver lining. 

🎢 Market swings are part of the investing game. 

Historically, 10% or more corrections happen every 12 to 18 months. 

While unsettling, these downturns often pave the way for future growth by clearing out excesses and recalibrating valuations.

The circle of life, some might say. 

Source: Morningstar Direct, to the end of 12/31/2023.

Reaping the benefits of financial savvy in a bull market is hard not to do, but true mastery shows in the downswings.

Tax loss harvesting is a powerful tool that becomes highly effective when timed correctly.

💼 Why Tax Loss Harvesting Matters Now

By selling investments that have lost value, you can offset gains in other parts of your portfolio, reduce your taxable income, and reduce your taxable income for the year.

Let’s say your $2 million investment portfolio shed 3% over the past few weeks. The $60,000 loss on paper might not be fun to stomach, but here’s how you could use tax loss harvesting to your advantage.

By selling your losing position and immediately reinvesting those proceeds into similar, but not “substantially identical” to avoid being on the wrong side of the “wash sale” rule, you’d be able to use those $60,000 to offset potential gains this year or next, 

The order of operations is as follows:

First, you’d offset short-term capital gains taxed at the ordinary income rate. This can be substantial, as high as 37%, in the higher tax brackets. 

If any amount of the loss is left over, you could apply it to long-term capital gains. This makes for excellent padding for positions you’re planning to exit and would like to avoid the tax hit (who wouldn’t!). Long-term capital gains taxes can be as high as 20%. 

Lastly, if there’s anything left, you can use it to offset up to $3,000 of your ordinary income per year until the amount is ultimately used. 

The optimal time to harvest losses is during downswings throughout the year rather than waiting until an arbitrary date in December.

🥐 Tax loss harvesting pairs well with other strategies

Together, Dollar-Cost Averaging (DCA) and tax loss harvesting can smooth out the impact of volatility. 

By investing a fixed amount regularly, you can reduce the average cost per share and take advantage of lower prices during downturns.

However, just be cautious about triggering the wash sale rule when using DCA. If you're selling a stock to harvest losses, ensure your DCA strategy doesn’t automatically repurchase that stock within 30 days.

🎉 Advanced Tax Loss Harvesting Hygiene 

Tax loss harvesting should be a year-round tactic. 

Setting aside specific review dates will allow you to identify tax loss harvesting opportunities regardless of market conditions. 

It’s also a springboard for any rebalancing acts your portfolio may need to be properly diversified.

Sector rotation is the practice of moving investments from one industry sector to another to capitalize on the changing phases of the economic cycle. 

During periods of economic expansion, sectors like technology and consumer discretionary often perform well, while defensive sectors like utilities and healthcare tend to excel during downturns.

By selling off assets in sectors with excessive exposure and repurchasing positions in sectors that lend better diversification, you can avoid the wash sale rule while mitigating risks in future downturns. 

⚠️ Don’t forget to keep clear track of your losses ⚠️

Keeping records seems like an obvious point, but you’d be surprised how easy it is for someone to lose track of their losses as life gets busy. 

Maintain a detailed record of the initial loss sum and how much has been used (or added to) each year. 

For example, suppose you had a $150,000 loss ten years ago. 

Over the next decade, you consistently had $10,000 capital gains yearly. You would apply $10,000 of your loss to offset those gains annually, leaving you with $50,000 in losses after ten years. 

Additionally, if you offset $3,000 of ordinary income each year, you'd have applied an extra $30,000 towards reducing your taxable income, reducing your loss to $20,000.

If, for some reason, you lost track of this loss amount and didn’t claim it, you’d be effectively overpaying for your taxes for an entire decade. 

📝 The easiest way to track your losses is through annual tax returns.

Capital losses and gains are reported on IRS Form 8949, which feeds into Schedule D of your tax return. 

Your tax software, accountant, or financial planner should carry forward the remaining loss automatically, but verifying this each year is essential, especially if you switch software or professionals. 

Schedule D will reflect how much of the loss has been applied to that year's gains and how much is left to carry forward.

Review your carryforward loss with your accountant before the end of each calendar year to ensure accuracy, which is especially important if you’re using multiple brokerage accounts. 

This is also an excellent time to plan which assets you’re keen on selling to avoid the capital gains tax. 

Making Cents of Market Volatility and Tax Harvesting

Nobody likes losing. 

But spending time in the market and experiencing a downturn isn’t exactly losing per se—it’s part of the economy's natural life cycle. 

Historically, markets recover, and appropriately diversified portfolios that track the market also tend to. Tax loss harvesting allows you to tap into the unique benefits of a down market, but it’s not just a means to reduce your tax bill. 

It gives you a proactive outlet to exert control over your overall portfolio’s health and reassess your investment philosophy as you close some positions and open new ones. 

By taking deliberate action when others might be paralyzed by fear, you’re positioning yourself to recover more quickly when the market rebounds. It’s the financial equivalent of turning lemons into lemonade, giving you more control over your portfolio’s trajectory even in challenging times.

Remember, the losses you harvest today could be the saving grace for that big payday down the line. Since these losses can be applied indefinitely until they run out, you could continue seeing the rewards for years to come. 

Until next week!

Dan from Tailored Cents

P.S. Follow me on LinkedIn for more tax gems to save you money.