Don't Mess With Taxes

This is how many investors felt after last week's stock market dive. (Photo by Angie)

The Dow Jones Industrial Average ended last week below 30,000 for the first time since January 2021.

Will it bounce back? Probably.

Will that happen soon? Probably not, at least not at the levels the market reached before concerns about historic inflation, the Russian invasion of Ukraine, U.S. corporate earnings, and the Federal Reserve's actions consumed investors.

I'm not a financial adviser, but I've been an individual investor long enough to know that if you can afford it, hang in there. The proverbial stock roller coaster will start clicking up the rails to a peak again.

But if you've had it with this particular ride, now could be a good time for tax loss harvesting.

Here you can scratch that itch to do something about your sinking holdings during this turbulent time, as well as potentially get a tax saving benefit.

I've blogged about this tax loss opportunity before, but that was a while back since the markets had been on a quite an upward run. So here's quick refresher.

Review your overall portfolio: First, don't act emotionally or rashly. OK, I know that point of no return has passed for some of you. But if you haven't yet sold everything, take a look at your holdings.

Now could be an opportunity to rebalance your portfolio.

Are all your holdings in the same sectors? Maybe it's a good time to diversify. In addition to being an opportune time to dump assets that have lost value, you can buy some at bargain prices to bulk up your investments in an area you had ignored.

Tax-deferred retirement accounts don't count: Many folks' connection to the markets is through their retirement accounts. If that's your case, then stop here. Tax loss harvesting is for taxable assets, only.

If you have a traditional IRA or 401(k) plan, those accounts are tax-deferred. If they've lost value, you can't take the distributions, i.e., sell them without taking a tax hit on the earnings. And if you're younger than 59½, you'll also face an early withdrawal penalty.

You might want to consider converting your traditional IRA to a Roth IRA now. My earlier post — The down market could make it a good time to convert a traditional IRA to a Roth — has more on this option.

But when it comes to basic tax loss harvesting, you must focus on your asset holdings that are taxable.

Begin with basis: Remember, you're looking at the amount of value lost. That starts with knowing your assets' basis.

The down and dirty basis calculation is the price you paid for the asset, adjusted by any commissions you paid, along with reinvested dividend and capital gains distributions on which you paid tax in earlier years.

For mutual funds, the average cost basis method is the one most often used. Here all your purchase prices are, as the name says, averaged together. Your broker or the fund company should be able to help you with the basis amounts.

You then take the price you got for your sale, and subtract your basis. When it's a loss, that amount can be used to offset any gains you have for the tax year.

A quick note here. It is possible for the market to go down, and you still realize capital gains. This sometimes happens to mutual fund investors. In this case, capital gains aren't necessarily connected to the market's overall performance. Rather, the gains are determined by the sale of securities within the fund throughout the year.

That means that even when markets are down, such security sales still can create a gain. And those gains must be paid out to shareholders at least once a year. Hence, those year-end fund statements with the previously mentioned capital gains distributions, which sometimes are surprising large given the way the markets went.

These payouts are more common in actively managed equity mutual funds. Again, this is a good reason to review your portfolio at least annually and decide if these types of taxable payouts are what you want at this point in your investing life.

Calculating your loss: If you have realized or expect such fund gains, your capital losses from your sales now can counter them. Here's a very basic example, excluding basis adjustments:

You bought 100 shares of Stock XYZ in 2015 for $100 per share. Your original purchase price was $10,000. XYZ's current price now is $25 per share, so you sell it all, netting $2,500. Your sale proceeds of $2,500 minus your original price of $10,000 gives you a $7,500 capital loss.

You can use that $7,500 in long-term capital losses to zero out any corresponding long-term capital gains this year, reducing your overall tax bill.

If you have more capital losses than gains, you can use up to $3,000 against ordinary income.

When you have more than three grand in excess losses, you can carry the loss forward into future tax years to offset gains then.

Don't tax wash your holdings: You decided to take a loss on an asset, but you really like its longer-term outlook. You want to buy some of it back, or another asset that's essentially the same.

Stop! Doing that will run you afoul of the wash sale rule.

The Internal Revenue Code wash sale rule says you cannot take tax advantage of a losing asset and then repurchase substantially the same stock within 30 days of the sale. This 30 days actually is 60 days, because it applies to 30 days before the sale and 30 days after the sale.

Basically, Uncle Sam's tax code doesn't allow you to sell a dog of stock solely to get a tax break.

The wash sale implications are obvious when you sell XYZ, take the loss, then buy more shares of the now cheaper XYZ. But what about XXYYZZ, which is the same type of asset?

The key descriptor here is substantially similar. And what's that? As I note in my book, The Truth About Paying Fewer Taxes, as in many tax situations it depends.

The Internal Revenue Service says you must consider all the facts and circumstances in your particular asset sale case. So do your due diligence, which is a good idea any time you're investing, and talk with your financial and tax adviser.

Breathe. Review. Take another breath: Yeah, I know you want to jump out of the market right now. And doing so could provide you some tax benefits.

But don't make any financial decisions based solely on the tax implications or consequences. Do what is right for your long-term fiscal well-being, and if there are tax breaks, be sure to claim them.

And join me in keeping fingers and toes crossed for the market to get back over that emotional and mental peace of mind mark of 30,000, which, by the way, is this week's By the Numbers figure.

You also might find these items of interest:

• It's capital gains tax gain harvesting season
• Place your eggs, er, money into different tax baskets
• Capital gains taxes: Proposed increase for the ultra-wealthy, an overview for the rest of us investors

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