Douglas Sacha / Getty Images
If you own any underperforming stocks or ETFs and want to save money on taxes next April, it may be time to start thinking about a popular strategy known as tax-loss harvesting.
According to a note Morgan Stanley published last week, October appears to be when investors most frequently employ the tax-savings method as the end of the year approaches.
The concept is fairly simple: if you own stocks that are down since you bought them, you can sell them and use that capital loss to offset your taxes.
There are a couple of ways to counter your tax bill through tax-loss harvesting. One way is by lowering your regular taxable income from things like salary or dividends. IRS rules allow you to reduce your taxable income by up to $3,000 in a year from capital losses. So, if you realized $9,000 in capital losses this year, you can spread that loss out over the next three years.
But the larger potential benefit, according to Chris Chen, a certified financial planner and the founder of Insight Financial Strategists, comes through offsetting capital gains. The strategy could especially come in handy this year, with the stock market near all-time highs and several mega-cap firms seeing huge gains.
To offset capital gains, an investor would close out both a position that's down and a position that's up, allowing them to cancel out taxes on the gain to the degree of the size of the loss. So a $2,000 loss would cancel out a $2,000 gain.
According to the IRS rule, one must then wait 30 days to reenter the position on the loss, while they can immediately buy back the position where they realized the gain. If the investor doesn't want to keep that cash on the sidelines during that month, however, they can move it into another security.
For example, Chen said that if an investor realizes a loss on Walmart but plans on buying back into the stock after 30 days, they might invest in shares of Target in the meantime, as it offers exposure to a similar market sector.
According to the Morgan Stanley note, stocks that are susceptible to downward price pressure due to tax-loss harvesting typically see the most downside in October.
Stocks that analysts rate highly — and are therefore presumably widely held — and yet have fallen by 10-25% in the first nine months of the year typically underperform the S&P 1500 and other similar stocks by 1-2% in October, the note said.
The timing is likely due to the fact that the end of the tax calendar is approaching, and investors want to lock in their losses to offset gains in case their losses shrink as the down positions start to recover in the last few months of the year.
However, according to Chen, there is no right time to harvest a loss, and one should consider striking while the iron is hot.
"I think it's a strategy that should be used year-round depending on where the market is going," he said. "If you happen to have a dip in the market in, say, March, that's a good time to do some tax harvesting, too."
