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Financial Planning in a Down Market

July 05, 2022
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In a down market, sound financial advice may include to ‘do nothing now’ or ‘stay the course.’ But sometimes, when your investments fall in value, it can create some financial planning opportunities, such as tax-loss harvesting. Basically, tax-loss harvesting is about minimizing capital gains taxes on your investment portfolio, helping turn financial losses into tax savings.

Here's how it works. When an investment in your portfolio declines in value, you can sell it, and then use the sold investment’s loss to offset any realized gains on other investments in your portfolio. You can then replace the original investment with a similar one to maintain the characteristics of your portfolio. For example, you bought stock ABC for $100, and it is now worth $50. You sell the stock at a loss of $50. At the same time, stock XYZ has increased $50 in value. The $50 investment loss from ABC can be used to offset capital gains tax on the $50 realized gains from stock XYZ. You then replace stock ABC with another investment that is not substantially identical. The end result is that potentially less of your money goes to taxes and more stays invested, hopefully working for you in a market recovery.

There are some details you need to be aware of though, including the wash-sale rule. This is a rule created by the IRS to prevent taxpayers from creating tax losses using investments. The rule defines a wash sale as one that occurs when an individual sells or trades a security at a loss and, within 30 days before or after this sale, buys a "substantially identical" stock or security, or acquires a contract or option to do so.¹ This means you cannot sell your ABC stock at a loss and turn around and immediately buy it back, you also cannot sell an investment in your own account at a loss and immediately buy it in your spouse’s account. The concept behind tax-loss harvesting is to offset taxable investment gains. Since qualified accounts, such as IRAs and 401(k)s, grow tax-deferred, they are not subject to capital gains taxes, therefore, you cannot sell an investment in a taxable account and immediately buy it in qualified investment account and deduct the loss.

If your losses are greater than the gains, you can also use tax-loss harvesting to offset up to $3,000 ($1,500 for married couples filing separately) of your ordinary taxable income. In addition, any amount over $3,000 can be carried forward to future tax years to offset future income. For example, you sell stock ABC at a loss of $5,000 and use it to off set a gain from stock XYZ of $1,000, you can apply $3,000 toward your ordinary income, and carry over the remaining $1,000 to the following tax season.

Clearly, there are immediate benefits of tax-loss harvesting, such as lowering your tax bill for the year. But possibly even more important are the medium- to long-term payoffs that you might get on the money you reinvest. Tax-loss harvesting is most beneficial when it generates tax savings while preserving your overall financial strategy. You should harvest losses when you can reinvest in a suitable, but not identical, replacement immediately or at a later date.

 Since there are considerations and restrictions to be aware of when employing this strategy, we recommend you first consult your financial advisor before taking action. With the help of the Ciccarelli Advisory Services team, it can be determined if this strategy should be a part of your financial plan. If you have any questions, please call our office and speak with a financial advisor.