Recent market volatility may be bad news for your portfolio. The good news? Your tax bill.
A strategy called tax-loss harvesting allows investors to use their biggest losers to reduce their taxes.
This way, you deliberately incur losses in a taxable account and sell holdings that have fallen in value. You use your losses to offset capital gains from other appreciated assets you've sold.
"Losses are valuable to the extent you have capital gains and $3,000 of ordinary income during the year," said Eric Bronnenkant, head of tax at robo-advisor Betterment.
"The last week and a half, the market declined substantially, you might want to think about selling some investments to benefit from those losses," he said.
Plummeting markets give you losses on paper, but you will need to realize them by selling some of your holdings while values are down.
Book the loss by the end of the year, and you can use it to offset any capital gains you realized elsewhere within the portfolio.
If your losses exceed your gains, you can apply up to $3,000 a year to offset ordinary income.
Maintain your portfolio's allocation by purchasing an asset similar to the one you just sold — just make sure you don't run awry of the wash-sale rule.
In a wash sale, if you sell the security at a loss and buy an asset that's substantially identical to it within 30 days before or after the sale, the IRS won't let you claim the loss on your return.
Wash-sale rules apply to all the accounts in your household. For instance, if you sell a holding in your taxable account but buy it back in your 401(k), you've violated the rule.
The same is true if you sell your loser in your brokerage account, but your spouse snaps it up elsewhere.
"The wash-sale rule applies per taxpayer, and a married couple is a taxpayer," said Thomas Neuhoff, CPA at Henry & Peters in Tyler, Texas. "You need to keep up communication between the two."
Dollar-cost averaging programs, in which you automatically invest into the market periodically, can also trip up investors.
For instance, you sell a losing mutual fund, but you forget to look back into the last 30 days when you were automatically snapping up shares. In that case, you've triggered a wash sale.
"You have to look backward, forward and across all accounts," said Neuhoff.
Tax-loss harvesting is part of a comprehensive financial planning strategy, and you shouldn't go it alone.
For one thing, you and your advisor or accountant will need to be aware of your tax situation and applicable rates. Those are key in figuring out whether selling your losers will work for you.
If you sell a security you've held for less than a year, you're recording either a short term-gain or a short-term loss. Short-term gains are taxed at the same rate as ordinary income, up to a top rate of 37%.
If you've held a security for more than a year and you sell it, you book either a long-term capital gain or a loss. Long-term capital gains are subject to a maximum tax of 20%.
Finally, there's nothing wrong with having a portfolio in the green. Losses are only valuable to the extent you have gains.
"If you don't have losses to incur, that's a good thing, too," said Bronnenkant.