Here's How a Bear Market Can Mean a Lower Tax Bill

There's one silver lining in poor stock market performance.

To say that the stock market hasn't had a great year in 2022 would be an understatement. Even after a recent rebound, the benchmark S&P 500 index is down by 17% compared to where it started the year, and many individual stocks have performed much worse.

One potential silver lining in a down stock market is a concept known as tax-loss harvesting. Essentially, if you sell any stocks, ETFs, mutual funds, or many other types of investments at a loss, you may be able to use those losses to lower your 2022 tax bill.

Your investment losses can be tax-deductible

You are allowed to use investment losses to offset capital gains from the sale of profitable investments, and you may also be able to use losses to reduce your non-investment income. Effectively, the government subsidizes your investment losses through the tax code.

Here are the general guidelines to keep in mind:

• You can use investment losses to offset capital gains. Long-term losses must first be used to offset long-term gains, and if there are any left over, they can then be used to offset any short-term gains. (Note: A long-term capital gain or loss is defined as coming from an investment you held for over a year.)
• The opposite applies as well -- short-term losses must first be used to offset short-term gains.
• If your investment losses exceed your capital gains for the year, or you don't have any capital gains, you can use up to $3,000 of investment losses to reduce your other taxable income.
• Any losses in excess of this $3,000 limit can be carried over to next year's tax return.

Know the wash-sale rule

It might initially seem like a smart idea to sell your losing stocks and simply buy them right back. But there's a rule that prevents you from doing that and claiming a tax loss.

Known as the wash-sale rule, the simple explanation is that if you sell a stock, you cannot buy a "substantially identical" investment within 30 days, or else you can't use the losses on your taxes.

What does substantially identical mean? Well, obviously you can't sell a stock and buy the exact same one. But it also has implications for ETF and mutual fund investors. For example, if you sell the Vanguard S&P 500 ETF and immediately buy the SPDR S&P 500 ETF, it can trigger the wash-sale rule, as these are almost identical investment vehicles. If you aren't sure, the best course of action is to ask a tax professional or financial advisor.

Don't sell just because your stocks went down

As a final point, it's not a good idea to sell stocks just because the share price went down. If you still believe in a business, there's a better argument to be made that it's a good time to buy.

However, if you have stocks that went down and you're losing faith in the business, it could be a different story. Maybe you're worried about the company's ability to stay profitable in a recession. Maybe you think management has made some questionable decisions lately. Or maybe you think there are better investments in which to put your money to work. In situations like these, taking a loss and moving on can help lower your tax bill.