When COVID-19 hit, the stock market tanked, then recovered and it’s still going through that cycle. You may never know, on a day-to-day basis, whether your retirement account is in a steep decline or making some modest gains.
While it’s too soon to tell how the impact of the worldwide pandemic will play out in the stock market, the prognosis isn’t good. But while losses in the stock market can be stressful, they can also be used to reduce your taxes.
The process is called “tax loss harvesting.”
How Tax Loss Harvesting Works
When assets such as stocks and bonds lose value, that loss is only made real – or “realized,” in investor terms – when the asset is sold. Investors can realize losses, i.e. sell off non-performing stocks at a loss – to offset gains in other areas of their portfolio, so they have to pay less in taxes overall.
For example, let’s say you own a stock that’s currently worth $15,000 more than it was when you bought it. Taking a realistic look at the market, you suspect the value of this stock may go down in the future – so you want to sell it now, and pocket the $15,000.
The issue with this is that once you sell that stock, you have to declare the $15,000 on your taxes – and the amount of tax you’ll have to pay will cut into your overall profit.
However, let’s say you own another stock that’s currently worth $12,000 less than it was when you bought it. Under normal circumstances, you might be tempted to hang onto this stock and give it time to increase in value.
But if you sell both stocks, your $15,000 gain from the first stock will be balanced by the $12,000 loss from the second. That means your taxable capital gain is reduced from $15,000 to $3,000—an amount that will cost you far less in taxes.
How it Reduces Your Taxes
This is “tax harvesting” – the act of offsetting the sale of profitable assets with the concurrent sale of underperforming assets. It’s a way to reduce your taxes, but it does entail a sacrifice – selling an underperforming stock and accepting the loss. If you believe the stock still has good long-term prospects, that can hurt.
However, you can legally buy back your underperforming stock, as long as you follow certain IRS rules.
What is a Wash Sale?
The IRS has a name for when you sell and then buy back a stock in quick succession to balance out your taxes. It’s called a “wash sale,” and it’s generally not allowed.
The IRS will consider your actions a “wash sale” if you sell an asset at a loss and then take one of these actions either 30 days before or after the sale:
- Buy securities that are more or less identical.
- Get more-or-less identical securities in a taxable trade transaction.
- Get an option or contract to buy securities that are more or less identical.
If you take any of these actions, the IRS can prevent you from deducting that loss on your taxes. But there are ways to get around this rule. For example:
- Wait at least 31 days before taking any of the above actions.
- Invest in a similar, but not identical, fund (such as a competitive fund within the same industry).
Got Investment Questions? Talk to an Experienced San Rafael Tax Accountant Now.
If you’re like a lot of investors right now, you’re probably dealing with losses not just in one area, but across your entire portfolio.
The good news is that in many cases, you can use those losses to offset up to $3,000 in non-investment income as well – including from your regular job.