Making lemonade from lemons

When your investments fall in value, it's not easy to take. Usually, the right response is to do nothing. But periodically, there is a way to take advantage of a bad market: tax-loss harvesting. You create a tax loss by selling, to use against future taxable gains. Then you buy something similar to replace the investment sold.

Tax-loss harvesting played out brilliantly in 2020. Some of you have the opportunity again now. Here's how it worked in 2020 and how it can work today.

March 2020 Market Plunge

Stocks dropped dramatically. If you owned them in a taxable account, you may have been sitting on a large unrealized loss. What many of our clients did was to sell and realize that loss, and immediately buy a similar fund. The IRS won't let you buy the same fund for 31 days; otherwise the loss is "washed away". But if you buy a similar fund, you remain invested and participate in any market rebound. In 2020, that rebound came quickly.

2021 was a big year for most of our clients, some of whom had large capital gains. Those who harvested losses in 2020 could use those losses to reduce or eliminate the tax on 2021 gains.

Tax-Loss Harvesting in Today's Market

The stock market has not fallen the way it did in 2020, and it rose so much in 2021 that many investors do not have meaningful stock losses. But the bond market is down around 10% -- the worst few months in decades. We are working with clients to identify opportunities to harvest those losses by selling bond funds and buying back into similar funds. They can use the realized losses to reduce taxable gains in 2022. If they do not have sufficient taxable gains in 2022, the losses can be carried forward indefinitely to use against gains in 2023 and beyond.

Three Tax-Loss Harvesting Cautions

1. This strategy does not work in retirement accounts, because gains and losses within those accounts are not taxable.
2. You may not actually reduce your long-term tax bill, if you later sell the new investment. You may only defer the tax. But a deferral can be valuable too, especially if you pay the tax when your bracket is lower. Many people never sell the new investment in their lifetime - in which case they reduced their tax bill.
3. Tax-loss harvesting is not a guarantee that you won't lose more in the new investment. We cannot forecast the markets. The strategy does not always work as well as it did in 2020 / 2021.

But, for many of you, realizing a loss today has value.

Lemonade from lemons.