Nobody likes to lose money
on their investments. But there's an even worse trap you can fall
into: making those losses permanent just to reap some tax savings
-- and then missing out on a big rally. Yet every year, many
investors do exactly that in an attempt to cut their tax
Below, I'll give you a simple way to avoid their fate. But
first, let's take a look at how so many people find themselves in
this uncomfortable situation in the first place.
The pros and cons of tax-loss harvesting
Every year as winter sets in,
investors start thinking about taxes
. Those with big gains look for ways to make sure they pay as
little tax as possible on them. But those who've lost money have
an opportunity to use the tax code to their advantage -- by
taking those losses as a deduction on their tax returns in
Specifically, losing stocks can give you capital losses, which
you can use to offset any capital gains you've realized. In
addition, even if you have additional losses above your gains,
you can take an addition $3,000 to deduct against other types of
income, including wages or investment income.
This year, unfortunately, there's no shortage of big losers
for some investors. Recently,
(Nasdaq: NFLX) ,
Green Mountain Coffee Roasters
(Nasdaq: GMCR) , and
(Nasdaq: DNDN) have all suffered setbacks due to specific
Many have documented Netflix's woes
in dealing with its price hikes and on-again/off-again Qwikster
did a good job of timing Green Mountain's uncertainties, while
Dendreon's slower-than-expected sales growth in cancer-fighter
Provenge came as a shock to many. Nevertheless, all of these
stocks have lost 60% or more from their 52-week highs -- so for
investors who were late to the party, losses abound.
In addition, some train-wreck stocks have been coming for a
much longer time.
Research In Motion
(Nasdaq: RIMM) , for instance, has seen its seemingly
once-impregnable moat of business-secure mobile devices dissolve
quickly to rival smartphone platforms.
National Bank of Greece
) has lingered throughout several episodes of the Greek sovereign
debt crisis, but along with other weak Eurobanks such as
Bank of Ireland
) , its shares are still struggling.
How you'll lose even more
At first glance, tax-loss selling seems simple: Sell the stock
and get your loss. But what if you think the stock is going to
The big problem with tax losses is that the IRS doesn't let
you repurchase your shares right away. Under the wash-sale rules,
you can't buy back the stock within 30 days. So the danger is
that between when you sell and when you can rebuy your shares,
the stock could skyrocket -- leaving you behind in the dust.
Fortunately, there are two ways you can protect yourself from
the double-indignity of suffering a big loss and then missing out
on the rebound. One alternative is to buy an ETF that tracks the
industry that the stock you're selling is in. So for instance, if
you have a big loss on financial stocks, then buying the
) could give you similar exposure while you wait out the 30-day
period. Later, you can sell the ETF and repurchase the individual
stocks you used to own once the wash-sale period is over.
The other way around the wash-sale rules is to "buy back" the
you sell them -- essentially doubling up on your position. Again,
that 30-day window applies, so if you buy shares now, you can't
sell them to reap your losses until mid-December. But this way,
if the stock rebounds between now and then, you aren't shut out
of those gains -- in fact, you'll end up with
Don't let the tax tail wag the dog
The important lesson with tax-loss selling is that you should
never let tax considerations take precedence over your primary
investing thesis. If you think a stock is worth holding on to
despite a big drop, then don't just automatically sell it to reap
a tax loss. With a little extra effort, you can avoid the
tax-loss trap and get the results you deserve.
Of course, the best solution to the tax-loss trap is to avoid
losses in the first place. In the Motley Fool's latest special
report, you'll get the names of 11 stocks that pay great
dividends and are poised for rock-solid growth in the years to
come. Just click here to learn about these stocks before everyone
else finds out about them.
Tune in every Monday and Wednesday for Dan's columns on
retirement, investing, and personal finance. You can follow him
Copyright © 1995 - 2012 The Motley Fool, LLC. All rights
reserved. The Motley Fool has a