How to Profit from This Sell-off (100% Guaranteed): Tax Loss Harvesting

By Matthew Hougan

The media is full of both good and bad advice on how to profit from this downturn.

Jason Zweig, for instance, has an excellent column in today's Wall Street Journal reminding investors to take a contrarian point of view. It gets at some of the nuances of what's going on inside people's heads when the market stumbles.

On the flip side, Jim Wiandt has listed out some of the more breathless "advisory emails" that piled up in his inbox last night. These suggestions aren't worth the electronic paper they're printed on.

You can find more advice on Marketwatch, MSN Moneycentral, TheStreet.com and a thousand other Web sites. For the most part, it all follows a similar pattern: don't panic, don't catch falling knives, and take a long-term view at your investments.

Motherhood and apple pie.

The problem with this kind of advice is that it doesn't give investors anything to do. It's really hard to sit on your hands at times like this, watching the markets crumble. Depending on your personality, you either want to grab some bargains or rush to sell whatever's left of your portfolio. Either way, you want to do ... something.

Here's what you can do: harvest your losses.

I know: b-o-r-i-n-g. Who cares about taxes when there's blood in the streets?

Well, you should care. Because right now, chances are, you've got some losers in your portfolio. And tax-loss harvesting lets you take action and profit from losses, without making rash decisions that would hurt your portfolio in the long run.

Here's an example of how it works. If you bought an S&P 500 index fund any time since mid-October 2005, you've lost money.  In a taxable account, you could sell that fund, realize the losses and then invest the proceeds in a comparable product, like a fund or ETF tied to the Russell 1000 Index. That second part is critical—you must immediately invest the money in a similar (but not identical) product to maintain your overall asset allocation. Otherwise, you risk making the kind of rash move that Zweig and others warn against.

The operating rule is the IRS' "wash sale rule." It says that you cannot claim a capital loss if you sell one position and replace it with a "substantially similar" position within 30 days. What "substantially similar" means is up for debate, but most people agree that two index funds tracking different indexes are not substantially similar. (You wouldn't want to sell one S&P 500 fund and replace it with another S&P 500 fund; that's too close for comfort.)

After 30 days, you can sell your Russell 1000 fund and invest the money back into the S&P 500 if you want.

The chance that the two funds will perform differently over the next 30 days is small. In August, for instance, the iShares Russell 1000 ETF (NYSEArca: IWB) delivered 1.37%, while the iShares S&P 500 ETF (NYSEArca: IVV) delivered 1.44%. Big whoop.

But the money you can make from harvesting losses is significant. You can use your realized losses to offset gains in other parts of your portfolio or, if you have no gains, you can deduct $3,000 from your income this year and carry over your other losses into 2009.

In almost any asset category you choose, you can find pairs of ETFs or index funds that let you tax-loss harvest effectively and efficiently. That's money in your pocket.

(While you're at it, now might be the perfect time to sell that high-cost actively managed fund you have held for years and move into a low-cost index-based ETF.)

Comments

[phdinsuntan...:]

srs and smile

2008 Sep 16 02:14 PM

[cyclingscholar:]

If you are taking a tax loss on a STOCK, life is easier. Say you sell 500 shares of GE for a loss. You can harvest this loss by buying a sp500 index fund. Since GE is only a few %age points of the fund, it should meet the IRS requirements.

2008 Sep 16 02:44 PM

[Rayn21:]

.. To pay less tax.

2008 Sep 17 06:59 AM

[Augustus:]

drvelocity,

You can get a deduction NOW for the losses - at least $3,000 worth. If you have gains, maybe harvest some of those too to use the rest of the losses. If you buy back into something like the IWM to replace the SPY, then you may end up with a long term gain at some point down the road - lower rate.

2008 Sep 17 09:39 AM

[Voltairema:]

Dr Velocity, think of it like this. You realize the loss now, and purchase something along the same lines. You can carry those losses up to something like 10 years. If you sell the new ETF or stock at a profit you can counter the capital gains with the losses you take now. Its a double win for you. No taxes and you are automatically better off then if you let the current stock get back into the green.

2008 Sep 17 09:42 AM

[Chris B:]

There's always opportunity - even in a falling market, as this article points out. I've always wondered about the standard advice not to make investment decisions based on taxes. Taxes are financially consequential, aren't they? Plus, they're 100% predictable, which can't be said for the market.

On a side note, I wonder if stock and bond prices will fall (and expected yields have to rise) if the 15% cap gains and dividend rates end. I suspect that these bits of legislation explain much of investors' bubble-inflating behavior in recent years, flipping real estate, commodities, and mortgage backed securities because low taxes increased the net yields.

2008 Sep 17 11:27 AM

[Indexor:]

You are betting that the stock WILL GO UP BY 114% in the next 5 years. What if it doesn't? What if it doesn't even get back to $10,000 in the next five years? What if it continues to fall farther over the next five years? What if Obama changes the capital gains rate? What if Obama discontinues the ability to write off any losses?

Take the write-off now while you can.

2008 Sep 17 04:53 PM

[Chris B:]

drvelocity,
Suppose you take your $3000 loss now, in 2008 and suppose you are in the 25% tax bracket. That $3000 loss offsets your income and reduces your taxes by either $750 or $450, depending on if you've owned the investment for a year or not. That $450-750 savings is guaranteed to you in January if you decide to harvest the loss. And guaranteed savings are as good as earnings! To avoid missing out on any possible rally, you immediately purchase another investment. You are now roughly back where you started investment-wise, except you've lost trading fees of $20 or so, and gained the tax savings of $450-750.

If your tax savings only amounts to $450, that's a 6.4% guaranteed return on your $7000 within 6 mos. AND you still get to invest your $7000 during that time. If you've owned it for less than a year, that $750 in savings equals a 10.7% guaranteed return on $7000.

If you decide to hold the original investment on the other hand, it could go up or down. It is impossible to assign probabilities to any outcome. In that way, you are in exactly the same situation as if you had switched to a different investment. Only in this case, both your trading fees and tax savings are zero.

2008 Sep 17 05:52 PM