Smart tax moves amid market volatility

[UNITED STATES] During periods of stock market volatility, many investors seek portfolio protection. However, experts warn that they may be missing out on a valuable tax planning opportunity. The practice, known as tax-loss harvesting, involves selling lost assets from a brokerage account in order to offset other investment gains and reduce taxes. Losses are often used to offset profits, such as those resulting from investment sales or capital gains distributions from mutual funds or ETFs.

Recent market downturns have made tax-loss harvesting particularly relevant in 2024, as investors grapple with fluctuating interest rates and geopolitical tensions impacting global markets. According to a report from the Investment Company Institute, outflows from equity funds have surged in recent months, creating a ripe environment for strategic tax planning. This trend underscores the importance of proactive portfolio management, especially during periods of uncertainty.

Once losses surpass earnings, you can deduct up to $3,000 from your ordinary income. After that, you can carry over any excess losses into subsequent tax years indefinitely. "It's looking for a silver lining on a pouring, rainy, cloudy day," said certified financial planner Sean Lovison, who founded Purpose Built Financial Services in Philadelphia. Experts recommend that investors consider tax-loss harvesting possibilities whenever the stock market is volatile.

Beyond immediate tax savings, tax-loss harvesting can also improve long-term portfolio performance by allowing investors to rebalance into more promising assets. A study by Vanguard found that systematic tax-loss harvesting added an average of 0.50% to 0.75% in after-tax returns annually over a 10-year period. This incremental gain can compound significantly, making it a valuable tool for both active and passive investors.

"That should be throughout the year," said Lovison, who is also a CPA. Tax-loss harvesting could be appealing, with the S&P 500 Index still down more than 15% from its all-time high in February as of lunchtime Tuesday. During Monday's session, the index briefly entered bear market territory, falling more than 20% from its record high.

Some investors may hesitate to realize losses, fearing they’re locking in underperformance. However, financial advisors emphasize that the strategy isn’t about timing the market—it’s about optimizing tax efficiency. “The goal isn’t to predict a rebound but to use the losses you already have to your advantage,” said Sarah Katz, a New York-based wealth manager. “It’s a way to turn market setbacks into future opportunities.”

Financial gurus suggest the following crucial points about tax-loss harvesting. While tax-loss harvesting appears straightforward, the present market downturn necessitates a "very granular" strategy, according to CFP Judy Brown of SC&H Group in the Washington, D.C. and Baltimore areas. After many years of market development, investment losses may include more recent acquisitions, according to Brown, a certified public accountant. She has been working identifying certain "tax lots," which are transaction records displaying an asset's acquisition date and price.

Technology has made tax-lot tracking more accessible, with many brokerage platforms now offering automated tools to identify loss-harvesting opportunities. Robo-advisors, in particular, have integrated tax optimization algorithms that scan portfolios daily for potential tax-saving moves. “The rise of fintech solutions has democratized what was once a manual and time-intensive process,” noted Brown.

Brown stated that methods are required to "quickly find those lots" to sell in order to take advantage of the tax loss harvesting benefit. One advantage of tax-loss harvesting is that you can sell assets at a loss and then reinvest in a similar investment to keep exposure, according to Lovison. However, you should be aware of the "wash sale rule," which prohibits the tax deduction for purchasing a "substantially identical" item within 30 days before or after the sale, according to the IRS.

While individual equities are simple to understand, experts say the IRS provides less clarity on how "substantially identical" applies to mutual funds and ETFs. For example, you could sell one large cap fund family for another from a different family when the holdings are slightly different, Lovison said. But if you’re repurchasing the same exact index holding identical funds, “that might not pass the [IRS] sniff test,” he said.