It's Time for Tax-Loss Selling
Harvesting losing positions from your taxable account can lower your tax bill and improve your portfolio.
Just a year ago, tax-loss selling (sometimes called tax-loss harvesting) was unlikely to be a profitable strategy for most investors—a niche tactic at best. Unlucky investors in individual stocks may have been able to pluck a loser or two, and buyers of unloved sectors like energy might have also been able to identify losing positions here and there. But the utility for mainstream investors was pretty limited. (With the benefit of hindsight, tax-loss selling was a wonderful opportunity in the baby bear market of March 2020, but my guess is that few investors took advantage of it.)
Fast forward a year, however, and losing positions have gotten more plentiful in many portfolios, especially if the holdings were purchased within the past year. The Morningstar US Market Index has shed about 14% of its value since the beginning of this year, and non-U.S. stocks have also posted double-digit losses. Growth-oriented stocks and funds, market darlings for most of the past decade, have swooned even more dramatically: The Morningstar US Growth Index dropped more than 28% for the year to date through May 2022, and the popular exchange-traded fund ARK Innovation (ARKK) has lost more than half of its value so far this year. The bond market is also off to a horrible start, with most core intermediate-term bond funds shedding 9% to 10% for the year to date through the end of May.
Assuming a portfolio's asset allocation was reasonable coming into such a downturn, the best strategy in challenging conditions like the present is usually to sit tight: Getting defensive now will do nothing more than turn paper losses into real ones. But tax-loss selling is in another category because it helps achieve multiple goals. Not only does it satisfy investors' natural tendency to take action amid volatile times—no small thing—but those losses can be used to facilitate other worthwhile activities that will benefit the portfolio plan—rebalancing, for example. Along with rising cash yields and the opportunity to pay less in taxes on IRA conversions, tax-loss selling is one of the few silver linings of a tough market environment.
Tax-loss selling involves selling positions in a taxable account that are trading below your cost basis—your purchase price adjusted for any commissions you paid and reinvested dividend and capital gains distributions. (You can typically find information on your cost basis on your fund company or brokerage firm's website.) The difference between your cost basis and your sale price—assuming the sale price is lower than the cost basis—is classified as a capital loss that can be used to offset an unlimited amount of capital gains or up to $3,000 in ordinary income. Those losses don't need to be applied in the year in which you realize them: If you take a loss this year but don't have gains to offset, you can carry the loss forward into future tax years. Note that tax-loss selling almost exclusively applies to taxable accounts (that is, nonretirement accounts). While it's technically possible to take a tax loss in an IRA, an investor would need to sell all of his or her IRA holdings to do so, and that's rarely the right course of action
To use a simple example of how tax-loss selling would work for a taxable account, let's say Sarah invested $10,000 in ARK Innovation a year ago. Today, her position is worth about $4,000. If she were to sell she could realize a $6,000 loss, which she could then use to offset capital gains elsewhere in her portfolio, thereby reducing her tax bill for this year. For example, if she wanted to reduce her position in another portfolio holding that had gained since purchase but had simply become too large a share of her portfolio, or if one of her other mutual funds made a capital gains distribution, she could use the tax loss on the ARK sale to offset those gains. If Sarah didn't have offsetting gains from her portfolio she could use it to offset up to $3,000 in ordinary income, or carry the loss forward indefinitely, to offset gains in future years.
Yet tax-loss sale candidates won't always be so obvious, especially because the current market downturn is still pretty new and many investors eschew individual stocks and narrowly focused funds like ARK. For long-term investors who use broadly diversified funds and ETFs as the building blocks for their portfolios, it's still likely that their holdings are trading above their cost basis. Selling a whole position would trigger a gain, not a loss.
In that case, such an investor's best shot at finding tax-loss sale candidates will be to cherry-pick specific lots of securities to sell—those with the highest cost basis that are most likely to result in a tax loss, assuming different lots of the fund were purchased at different intervals. That's called the specific-share identification method of cost basis, and it's especially valuable at times like this. Right now, for example, someone using the specific-share identification method might unload high-cost shares purchased in 2020 or 2021, before the market started to slide, while leaving lower-cost-basis shares in place.
The average method, whereby all of the investors' purchase prices are averaged together, is usually the default cost-basis method for mutual funds, though it's possible to override it by changing your cost-basis election on your provider's website. The averaging method is simple and clean, but it obviously doesn't allow for surgical tax-loss selling in the way that specific-share identification does. And it's important to note that if you've sold shares using the averaging method in the past, you'll have to stick with it in the future.
Meanwhile, most brokerage platforms use "first in first out," or FIFO, as the default cost-basis election for stocks. That won't be a fit for investors looking to unload recently purchased shares, obviously; specific-share identification would be the way to go in that situation, too.
One tricky aspect of tax-loss selling is that the very holdings that are the most likely to yield a tax loss may also be unduly beaten down and ripe for recovery. The typical stock in Morningstar analysts’ coverage universe, for example, is currently trading at a 12% discount to its fair value, and certain sectors—consumer cyclical and technology, for example—look cheaper still.
If you wish to maintain exposure to the same market segment that you're selling out of, you can't simply rebuy the same security right away and still take a tax loss; you need to wait more than 30 days or else the tax loss won't be allowable. Nor can you rebuy what the IRS considers a "substantially identical security" within 30 days of selling a holding without disallowing the tax loss. For example, you couldn't sell out of the mutual fund version of Vanguard Total Stock Market Index (VTSAX) and buy the ETF version (VTI) instead. But you could sell an actively managed U.S. equity fund and buy an index fund instead; you could also replace a stock with another stock of a different company that operates within that same market sector.
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Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.