How a Simple Tax Tactic Could Help You Offset Stock Losses This Year

If you sold stocks during the market turmoil this year and captured a loss on that sale, you might consider using a tactic known as tax-loss harvesting to help you save money on taxes.

“At a basic level, tax-loss harvesting is selling an investment for a loss, on paper, and using it to reduce your taxes,” says Filip Telibasa, a certified financial planner and owner of Benzina Wealth. “Losses can either be used to offset gains realized in other areas or to reduce up to $3,000 of your income.”

Here’s what you need to know about using the strategy.

A Closer Look at Tax-Loss Harvesting

Tax-loss harvesting can be a good strategy to use in a volatile stock market, helping you take advantage of any losses you may experience.

“A volatile market is the best time to use tax-loss harvesting since there is a lot of movement and therefore opportunities to capture short-term losses,” Telibasa says.

In addition to saving you money on taxes, tax-loss harvesting can help to rebalance your portfolio.

“Your investments are out of balance when individual positions move in different directions. By selling positions at a loss, it helps to even things out,” Telibasa says.

Another thing to keep in mind is that a loss can be carried over from one year to the next.

“When you sell an investment at a loss, you can use that loss to offset gains from other investments you sold at a profit. If your losses exceed your gains, you can use up to $3,000 of that excess to reduce your ordinary income for the year,” says Alvin Carlos, certified financial planner and founder of District Capital Management. “Any remaining losses carry forward to future tax years. This can result in a smaller tax bill today and help soften the tax impact of gains in the future.”

Watch Out for Wash Sales

According to the IRS, a wash sale occurs when you sell a security at a loss and acquire the same “substantially identical” security within 30 days of the sale date, both before and after the sale date. When this occurs, the taxpayer cannot deduct the loss on the security.

“The purpose of this rule is to prevent investors from selling assets purely to generate a tax loss and then immediately repurchasing the same or very similar assets to maintain their investment position,” says Austin Lee, a certified financial planner and founder of Lee Financial Group.

To avoid a wash sale, stick with buying a similar but not identical stock following tax-loss harvesting.

“Avoid buying the same or substantially identical security, such as the same ETF or stock, within 30 days before or after the sale,” says Christopher Stroup, a certified financial planner and founder of Silicon Beach Financial. “Instead, swap into a similar but not identical holding. For example, if you sell an S&P 500 index fund, consider buying a total market fund to maintain exposure.”

Another way to avoid a wash sale is to wait 31 days or longer from the date of the sale to make a new purchase.

Only Applies to Taxable Brokerage Investments

Tax-loss harvesting cannot be applied to retirement accounts, as these accounts are tax-deferred already.

“Tax-loss harvesting only applies to taxable brokerage accounts. Retirement accounts like 401(k)s and IRAs grow tax-deferred, so gains and losses inside them don’t affect your annual tax bill,” Carlos says. “That’s why you don’t harvest losses in those accounts; there’s no tax to offset.”

The Bottom Line

Tax-loss harvesting is one way to make up for losses in the stock market. Selling at a loss will help to offset gains from other investments and will lower your tax bill. There are a lot of losses with a volatile stock market, so it is a good time to consider this tactic, which can only be used in taxable brokerage accounts.

Just be careful about the investment you choose before and after the sale of a loss. If you make an investment that is substantially identical to the one you sold at a loss within 30 days before or after the sale, you won’t be able to deduct the loss on your tax return. To avoid this, choose to buy similar but not identical investments within the 30 days before or after the sale of a loss, or wait 31 days or longer to make a new purchase. Both strategies will allow you to deduct a loss on your tax return.