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 bills.
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 April.
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, Netflix (Nasdaq: NFLX ) , Green Mountain Coffee Roasters (Nasdaq: GMCR ) , and Dendreon (Nasdaq: DNDN ) have all suffered setbacks due to specific news-related items. Many have documented Netflix's woes in dealing with its price hikes and on-again/off-again Qwikster proposal. David Einhorn 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 (NYSE: NBG ) has lingered throughout several episodes of the Greek sovereign debt crisis, but along with other weak Eurobanks such as Bank of Ireland (NYSE: IRE ) , 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 bounce back?
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 SPDR Financial (NYSE: XLF ) 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 shares before 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 twice the reward.
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 on Twitter here.