By Daniel Prince, CFA
Markets have been roiled in 2022, as persistent inflation and rising rates have spooked investors. The pain has been widespread: U.S. stocks and bonds have both declined by more than 8% year-to-date.2 Since 1976, there have only been 10 months where both stocks and bonds have each posted losses greater than 2%.3
Growth of hypothetical $100: U.S. equities vs. U.S. bonds
It can be difficult to hold on to investments while markets whipsaw and to learn the bitter truth that markets don't always deliver outsized, orderly returns. But as the old saying goes, "what seems like a curse may be a blessing." Investors can keep their long-term goals in sight, while taking steps to mitigate some of the pain of seeing their investments decline.
Tax-loss harvesting is the act of selling an investment below its purchase price to realize a loss in a taxable account. Investors may use sales proceeds to purchase a comparable investment to maintain a similar exposure. Harvested losses can be used, dollar for dollar, to offset realized capital gains. In addition, investors can offset up to $3,000 per year of regular income with realized losses. If an investor recognizes more losses than gains, or has already offset the $3,000 income cap, losses can be carried forward indefinitely.
Rules preclude investors from recognizing losses and then quickly buying back their original investment. These "wash sale" restrictions mandate that an investor cannot realize a loss on the sale of an investment and then buy a "substantially identical" security, beginning 30 days before and ending 30 days after a security sale.4 Depending on the specific securities involved, executing a tax loss harvesting strategy and reinvesting to maintain a similar exposure can be accomplished with ETFs.
Over 70% of stocks of in the U.S. stock market have fallen in price year-to-date, while U.S. bonds recently saw their largest drawdown since 1980.5 Selling single U.S. stocks at a loss and buying an ETF that seeks to track a U.S. broad based index may avoid violating wash sale rules while helping to stay invested. To be sure, tax loss harvesting opportunities are plentiful; many formerly high-flying stocks have fallen considerably, some of them as much as 50% year-to-date. Similarly, investors can consider selling out of individual bonds and buying diversified fixed income ETFs as a way to bank losses.
Tax loss harvesting can also apply to funds. Selling out of a mutual fund/ ETF at a loss and buying a different fund with a similar objective can help position your portfolio for future growth while attempting to reduce your total tax bill. Alternatively, investors may want to consider shifting some holdings to an ETF with a different objective. In both scenarios, tax benefits may be unlocked with the aim of staying invested.
In addition to sticking to your overall investment plan, maintaining good portfolio hygiene can include striving to achieve more favorable after-tax results. While current market volatility may get your portfolio down, consider tax-loss harvesting to get your tax offsets up.
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1 Source: IRS Topic No. 409 Capital Gains and Losses, as of 12/31/2021. Harvested losses can be used, dollar for dollar, to offset realized capital gains, thereby eliminating tax liabilities. In addition, investors can offset up to $3,000 per year of regular income with realized losses. If an investor recognizes more losses than gains, or has already offset the $3,000 income cap, current rules allow for losses to be carried forward indefinitely.
2 Source: Morningstar Direct, as of May 31st, 2022. The S&P 500 Index (stocks) and Bloomberg US Aggregate Index (bonds) fell 14.4% and 8.5%, respectively from Jan. 1, 2022, to May 26, 2022. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
3 Source: Morningstar Direct, as of May 31st, 2022. US Equities and US Bonds are represented by the S&P 500 Index and Bloomberg US Aggregate Index respectively.
4 The Internal Revenue Service has not released a definitive opinion regarding the definition of "substantially identical" securities and its application to the wash sale rule and ETFs. The information and examples provided are not intended to be a complete analysis of every material fact respecting tax strategy and are presented for educational and illustrative purposes only. Tax consequences will vary by individual taxpayer and individuals must carefully evaluate their tax position before engaging in any tax strategy. The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective. The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision.
5 Source: Morningstar Direct, as of May 30th, 2022. U.S stock market refers to the S&P 500. U.S. bonds refers to the Bloomberg U.S. Aggregate Bond Index. The Bloomberg U.S. Aggregate Bond lost 12.74% from August 1, 1979, to Feb. 29, 1980, and 11.08% from August 2020 to April 30, 2022.
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