Why Smart Investors Love Market Dips: The Power of Tax-Loss Harvesting
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Market downturns can feel painful. Think about what happened last week with NVIDIA and Broadcom. [Read More Here]
As the title states, smart investors love market dips and know how to turn losses into tax savings. Tax deduction creation or Tax-loss harvesting is a strategy that allows you to sell investments at a loss to offset capital gains and reduce your taxable income. [IRS Guidance]
How It Works
Sell Underperforming Investments – If you own stocks, ETFs, or mutual funds that have dropped in value, you can sell them to "harvest" a capital loss.
Those losses can be used in one of two ways
Use Losses to Offset Gains – The loss can be used to offset capital gains from other investments, reducing your taxable gain.
Offset Ordinary Income (If Needed) – If your losses exceed your gains, you can use up to $3,000 of losses per year to offset regular income ($1,500 for married filing separately).
Carry Forward Excess Losses – If you have more than $3,000 in losses, you can roll them forward to future years to continue offsetting gains.
You might be thinking: “Finn, why would you want your investments to underperform?!?”
Let me walk you through an example:
Example
Bob buys equal amounts of Funds A, B, and C. They all have different holdings, but all the holdings are high-quality companies that have been stress-tested. Here are the allocations:
Fund A: $10,000
Fund B: $10,000
Fund C: $10,000
Total Investment: $30,000
After a year, Fund A underperformed (still good quality, but it decreased in value), Fund B stayed flat, and Fund C increased drastically. Here are the new allocations:
Fund A: $7,000
Fund B: $10,000
Fund C: $20,000
After a review, Bob decides to keep his allocation in Funds B & C. In Fund A, we sold the current fund for a loss and bought a similar allocated fund (Fund X). This allows Bob to have close to the same exposure as he did before but capture the loss on paper for tax purposes. Here is his allocation after that change:
Fund X: $7,000
Fund B: $10,000
Fund C: $20,000
Total Investment: $37,000
So, in his account, he actually has an unrealized gain of ~$7,000, but on paper, when reporting his Gains & Losses to the IRS, he has a loss of ($3,000) to help offset his other income sources.
Note: This process can even be automated to occur on a daily basis and track the exact returns of the S&P 500 index but in a much more tax-efficient manner. [reach out here if you want to learn more]
Key Points to Remember:
This has to be in a taxable nonretirement account (not IRAs or 401(k)s).
Avoiding the Wash Sale Rule - The IRS disallows tax-loss harvesting if you buy the same or a “substantially identical” investment within 30 days before or after selling at a loss. To stay compliant: Replace the sold investment with something similar but not identical (e.g., a different ETF or mutual fund in the same sector) or Wait 31 days before repurchasing the same security.
Who Should Consider It?
EVERYONE with a taxable account
Bottom Line
Tax-loss harvesting is an easy way to make market volatility work in your favor. By strategically realizing losses, you can lower your tax bill and keep more of your investment returns.
