Not every stock pick can be a winner. But even the losers can have a silver lining at tax time—if you're ready to cut your losses. It's a financial move called tax-loss harvesting, and taking advantage of it can not only ease the sting of losing money when investing in the stock market; it can also lower your taxes.
Christine Benz, director of personal finance for Morningstar, a Chicago-based financial research and ratings company, explains that with tax-loss harvesting, you can cut your losses and "use them to offset the winners. It can be a great strategy in volatile markets."
Here's what you need to know.
What is tax-loss harvesting?
Tax-loss harvesting happens when you sell a security for less than you paid for it. On your taxes, you can subtract the money you lost on the investment from your stock market profits to lower the taxes you owe on your investing profits.
"It is worthwhile to check to see if you have securities that you have purchased that are now trading below your cost basis," Benz says, referring to the cost paid to purchase a security.
You do have to sell your shares at a loss to be able to account for it on your taxes; an underwater investment in your portfolio doesn't count.
Tax-loss harvesting only applies to taxable brokerage accounts, so you'll have to find another way to stomach dealing with any losses in your retirement accounts. "Most people invest through some type of a retirement account," Benz says. "If that's the case, none of this is applicable to you."
If you're investing through a financial planner or robo advisory service, tax-loss harvesting may already be happening behind the scenes of your portfolio outside of your retirement accounts. "We do tax-loss harvesting in all of our portfolios to see where we can realize a loss so we can offset some of the gains," says Andy Leung, a private wealth advisor with Procyon Partners in Connecticut.
If there's a stock that you held high hopes for but have since given up on, it could be a prime candidate for tax-loss harvesting. "It's for when you want out," Leung says.
What happens if you don't have any capital gains?
If you didn't make any money selling stocks or mutual funds—or lost more money than you made investing one year—you can leverage those stock market losses to lower your income taxes, possibly for years to come.
Each year, investors can apply up to $3,000 in stock market losses to lowering their taxable ordinary income. Losses over $3,000 can be carried over for savings in future years. For married people filing their taxes separately, that figure is $1,500 per person.
If you do plan to take this approach, it's probably well worth it to invest in personal tax preparation help.
The fine print
While you have until April 15 to make contributions to your prior-year retirement accounts, you'll have to sell off losing positions by the last trading day of a tax year for it to count as a loss for that tax year.
"All kinds of people try to game that," Leung says. "There are a lot of large institutions that will do tax-loss selling toward the end of the year, so it can create weakness in stocks."
You also can't turn around and buy back the same or similar security within 30 days of selling it. If you do, it's considered a wash sale by the IRS, and you can't use the loss to catch a break on your taxes. You should consult a tax advisor if you're not sure whether an investment you're considering would be considered a wash sale.