It’s August 2024, a snapshot in time when tax loss harvesting could have been used to significant effect. 

The S&P 500 saw its biggest single-day drop since September 2022. The Dow shed more than 1,000 points. The Nasdaq 100 erased almost $1 billion in market value. The Nikkei 225, Japan’s benchmark stock index, saw its worst day since 1987

The VIX, Wall Street’s Fear Gauge, hit levels only seen in the 2008 Financial Crisis and the 2020 pandemic.

Regardless of whether you’re an experienced investor or it’s your first rodeo, downward market swings can be a gut-lurching experience. 

Should I sell now and just cut my losses? 

I knew I should have kept my money in my high-yield savings accounts. 

Well, looks like we’re not getting guac on the Chipotle this week.

It’s essential to remember that market volatility is an inherent aspect of investing, often manifesting through significant sell-offs that can send shockwaves through the financial world. 

Though these days can be alarming, it's essential to recognize that market corrections are a natural part of the investment cycle. 

Historically, markets experience corrections of 10% or more approximately once every 12 to 18 months, making them a routine, albeit uncomfortable, occurrence.

Believe it or not, but with these corrections, things would get better.

They help eliminate excesses, recalibrate valuations, and ultimately set the stage for future growth. 

In the face of market volatility, here are several strategies to help investors stay grounded and focused on their long-term goals:

Stay the course. Market fluctuations are normal. Long-term investing requires patience and resilience. Avoid making impulsive decisions based on short-term market movements.

Diversify your portfolio. Make sure your investments are spread across various asset classes and sectors. 

This is especially important if you work in an industry like tech and receive equity and stock compensation, as this automatically creates a density point in your diversification. 

Periodically reassess your financial goals and risk tolerance. 

This goes hand in hand with diversification, for better or for worse. 

Let’s say Kyle scooped up a bunch of tech stocks in 2016, which rose by 100x since. Kyle has become considerably wealthy. 

The stocks might have been a minor portion of his portfolio at the time of purchase, but it could make up 99% of his net worth today due to its astronomical gains. 

Proponents of diversification would advocate for Kyle to strategically sell off some of the stocks and diversify into something less volatile, like real estate, index funds, money market funds, or just cash in a HYSA– ideally, a mix. 

Sure, he may miss out on future gains on his stocks, but this helps protect him from losing his shirt in the case of future volatile downturns.

Consulting a professional, specifically for the tax implications of your investing, can be worth its weight in gold. 

For example, if Kyle chooses to sell off some of his tech stocks, he’d be responsible for paying either short-term capital gains tax if he purchased any more within 365 days or long-term capital gains tax if it was from his original purpose. If he also has a high-paying job, he could be liable for a Net Investment Income Tax (NIIT), an additional 3.8% tax on his investment income. 

However, he could effectively offset some gains by strategically selling off losing positions permanently or purchasing them back after 30 days a la tax loss harvesting. 

This way, he could use any time the market burns him as an opportunity to profit from other positions.

Tech stocks tend to be very volatile and are extreme examples of how complicated tax treatment can get. Still, salary, equity, and other investments can also be incredibly nuanced. 

Tax Loss Harvesting in Action

Tax loss harvesting is a relatively straightforward concept in theory, but it gets a bit more hairy when the rubber meets the road. 

Profile: Alex is a Head of Content at a prominent tech company with an annual income of $400,000, falling in the 35% marginal tax bracket. 

He has an investment portfolio valued at $2 million.

Alex and his financial planner review his portfolio during their Q4 checkup. They notice that while most tech stocks have appreciated, some investments have decreased significantly. 

He’s down $17,000 on one stock and $5,000 in another, for a total realized loss of $22,000.

Alex bought and sold some other tech shares within the same 365 period, realizing a capital gain of $20,000. Rather than paying a 35% ($7,000) ordinary capital gains tax on the sale, he’d use the $22,000 in losses to offset this gain entirely, reducing the taxable capital gains to zero.

To comply with the wash sale rule, Alex avoids repurchasing the specific tech stocks he sold for at least 31 days. The wash sale specifies he can’t buy anything “substantially identical,” but what does that actually mean? 

That’s where touching base with a financial planner is handy.

His financial planner notes that selling shares of a tech stock and buying an index fund that holds that tech stock is generally not considered a wash sale and is unlikely to be flagged; an index fund typically holds a diversified portfolio of stocks, and the IRS does not typically consider it substantially identical to an individual stock, even if the stock is part of the fund.

The remaining $2,000 loss (since $22,000 in losses offset $20,000 in gains) can be used to offset ordinary income, reducing taxable income by $2,000. This results in a tax savings of $700 (35% of $2,000).

If Alex had more losses than gains and the $3,000 limit for offsetting ordinary income is exceeded, any additional losses could be carried forward to future tax years.

Alex then reinvests the tax savings into a diversified index fund to maintain the desired asset allocation and continue growing the portfolio.

Dollar-Cost Averaging + Tax Loss Harvesting in a Downswing

While tax loss harvesting allows you to offset gains with losses, DCA helps manage the risks of volatility.

Dollar-cost averaging (DCA) involves regularly investing a fixed amount of money into the market, regardless of its fluctuations. 

The strategy posits that by consistently buying into the market over time, you purchase more shares when prices are low and fewer shares when prices are high, which results in a lower average cost per share over the long term, potentially reducing the impact of volatility.

It’s one of a handful of the most valuable investment strategies that can be automated. 

However, it could trigger the wash-sale rule if you sell stock with the intention of tax-loss harvesting and then automatically buy it back within a thirty-day period. 

DCA can help alleviate the stress of investing during volatile times by smoothing out the purchase price of your investments over time. It gradually builds up your position so you can reap the benefits when the market recovers. 

By utilizing both DCA and tax loss harvesting, you can navigate market downturns more effectively, positioning yourself for long-term financial growth while minimizing the impact of short-term market fluctuations.

Making Cents: The Importance of a Long-Term Perspective

You’ve likely heard the adage that successful investing is not about timing the market but about time in the market. 

I’d posit that it’s not just about time in the market but also about what you do with it. 

This doesn’t mean day trading and attempting to arbitrage any potential opportunity, but using the ups and downs to give yourself every advantage possible come tax time. 

By sticking to your financial plan, staying informed, and focusing on your long-term objectives, you can confidently navigate market volatility's ups and downs.

 

This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.