Updated: May 18, 2020
Here we are in very turbulent times in the stock market. For long-term investors, it is best to stay the course because, as history tells us, the market rewards long-term investors. I do not advocate timing the market as an investment strategy or trading frequently. However, there are some adjustments that an investor could pursue in these volatile times:
Sell positions on investments that have been losing value over the past 3-5-10 year period.
Purchase stocks of solid companies that meet your criteria for long-term investment
Rebalance the portfolio to match your risk tolerance i.e. move towards defensive position or reduce concentrated holdings
Net Losses are deductible from Ordinary Income
One side effect of selling losers and rebalancing your portfolio is that you may incur losses that can offset gains from selling other positions. Besides, if you have a total net loss (total losses more than gains) in a year, the tax law allows you to deduct up to $3,000 (married filing jointly) or $1,500 (single filer) of net loss from your ordinary income. And if the losses are more that $3,000, you are allowed to carry forward the losses to the subsequent years. For example, you dumped some bad performing funds for a loss of $15,000 and sold some other funds for a gain of $8,000. The net loss of $7,000 ($8,000 - $15,000) will offset this year's income by $3,000, reducing your taxes by $660 assuming 22% marginal tax bracket. The remaining $4,000 ($7,000 - $3,000) in losses can offset any capital gains in the next year or carried forward.
Tax-Loss Harvesting Strategy
Interestingly, the capital gains and losses can be from any sale, including real property. This method of using losses systematically against gains is called "tax-loss harvesting". This strategy is used by many high-income earners to take profits and sell losers in their portfolio to improve their after-tax return every year, However, there are important caveats as to what kind of losses are permissible. Of course, this strategy works only in taxable accounts and not in tax-deferred accounts. Newer robo-advisor platforms, like Betterment or Wealthfront, claim to use regular tax-loss harvesting algorithms to boost your after-tax returns but it will only work if they have purview of all accounts as described below.
Beware of Wash-Sale Rule
IRS has put restrictions called the "wash-sale rule" when these losses are not deductible from income. "A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you buy substantially identical stock or securities" according to IRS. This purchase not only applies to transactions in taxable account but also applies to your retirement such as IRA, 401(k) accounts including dividend reinvestments. It also applies to option contracts, securities in your spouses accounts and 529 College Savings accounts. For example you cannot take losses from selling ETF that tracks S&P 500 say SPY and buy it within a month in same or another account including another S&P 500 ETF such as VOO because these would be considered substantially identical. But if you bought IWM ETF which tracks Russell 2000 Index or a large-cap mutual fund, the losses will be deductible. Because wash-rule casts such a wide-net , it is important to be aware of all the transactions in your and your spouse's portfolio including retirement accounts and other automated investments. Also, you have to be careful about selling stocks at the year-end to write-off losses and not buying similar position in the beginning of the new year before the 30-day window has elapsed.
Opportunity to Rebalance
The current down market gives an opportunity to "clean up" your portfolio to offset some losses against realized gains thus reducing the taxes when there is a net loss. While tax-loss harvesting allows you to deduct net losses of $3,000 from your ordinary income, you should not make portfolio decisions purely based on tax implications or as saying goes "do not let the tax tail wag the dog"! Evaluating your portfolio, rebalancing and taking advantage of tax-loss without triggering the wash-sale rule can be complicated. Please contact me for help regarding your portfolio decisions.