Over the past week, we’ve witnessed a painful stock market meltdown. It started in late July, intensified through the debt ceiling debate, and culminated with a 7% decline yesterday in the wake of the US credit downgrade. But with every challenge comes opportunity…
Harvesting your losses
As long as you have a sufficiently long time horizon, market turmoil like this is nothing more than a bump in the road. Instead of panicking, my wife and I are sticking to the plan and trying to make the best of a bad situation. For us, this means that we’re doing a bit of tax loss harvesting.
The term “tax loss harvesting” refers to selling shares to book your losses, replacing them with a similar, but not identical, investment vehicle (so you don’t trigger a wash sale or miss out on a near-term recovery) and writing off the losses at tax time.
As it turns out, investment losses (i.e., “capital losses”) can be used to offset investment gains (i.e., “capital gains”). And if you don’t have any (or enough) gains to offset, you can use your losses to offset ordinary income. While youâ€™re limited to offsetting $3k/year of ordinary income, you can carry your losses forward until theyâ€™re used up.
In the 25% tax bracket, every $3000 in ordinary income that you offset equals a $750 tax savings – not bad for a bit of paperwork, right? And if you book enough losses, you can do this for several years to come.
Avoiding a wash sale
As I noted above, the main thing that you need to look out for is triggering a wash sale. The wash sale rule requires investors to wait at least 31 days after selling a security for a loss before repurchasing the same security, or a “substantially identical” investment. If you buy back in within 30 days, the IRS will treat it as if you never sold in the first place, and youâ€™ll lose the ability to claim a loss.
You should also keep in mind that the IRS will also treat it as a wash sale if you make your purchase within the 30 days before the sale of your downtrodden shares, so you canâ€™t simply buy shares ahead of the sale to avoid triggering a wash sale.
Once the 30 day window has elapsed, you’re welcome to exchange back into the original investment. Just be aware that, if the market has recovered in the mean time, you might wind up booking gains when you switch back, wiping our part (or all) of your tax savings. Of course, if things continue to head south, you could wind up booking even more losses when switching back.
As far as “substantially identical” goes, the IRS hasn’t provided a clear definition. When it comes to stocks, this isn’t a huge deal. In general terms, you should be safe selling one company and buying another, even if it’s in the same industry. But for mutual funds and ETFs, things are a bit murkier.
The general consensus is that you can’t, for example, sell an index mutual fund and buy the equivalent ETF. Likewise, you can’t sell a fund from one company and buy another company’s fund that tracks the same index (e.g., Vanguard 500 Index vs. Fidelity Spartan 500 Index). But you can swap out investments that track different indices, even if they’re from the same mutual fund family (e.g., Vanguard 500 Index vs. Vanguard Total Stock Market).
Of course, I’m not a tax professional. I’m just sharing what I believe to be true based on my own research. If you’re nervous about this sort of thing, you’d be well advised to do your own research, or to check with an investment or tax pro.
Choosing loss harvesting “partners”
In general terms, when you trade one investment for another while tax loss harvesting, you’ll want them to fill the same niche. To be sure that’s the case, I recommend going to Google Finance and punching in the ticker symbol of your current investment.
Once the chart comes up, add the symbol of the replacement investment using the “Compare:” box. Now click out to a longer timeframe – say 5 or 10 years. Do the prices of the two investments track each other fairly well? If so, great. You’ve found a good match. If not, keep looking.
So, dear readers, have you taken advantage of the recent turmoil by harvesting some investment losses?