Use Your Losses Without Missing the Rally

With April 15 now just a bad memory, taxes are probably the last thing on your mind. But if you're still smarting from all the money you had to pay the IRS earlier this month, don't just suffer -- do something about it.

Harvesting tax losses is a silver lining when you suffer steep declines in the stock market. But a host of rules -- such as limits on how much in losses you can claim on your return and restrictions that prevent you from claiming losses on shares you sell and then immediately buy back -- make tax-loss harvesting not only more complicated, but also potentially costly.

Luckily, though, there's a safer way to take tax losses that could make it easier for you to use those losses as tax breaks for years to come.

Limiting your losses
For many investors, filling out your tax returns this year added insult to the injury of last year's horrific performance in the stock market. Even if you suffered huge losses on stocks and mutual funds, you couldn't use more than $3,000 to offset other types of income, such as wages or interest and dividend income. And while you could use them to offset capital gains, the odds are good that you haven't seen a whole lot of gains lately.

Those limits convinced many people not to bother selling to reap tax losses last year. And in many cases, they fared better than those who did.

Bad timing
The reason why some tax-loss harvesters got burned late last year has to do with wash sale rules. Those rules require you to wait more than 30 days to buy back stock you sell if you want to claim a tax loss.

But if you waited until early December to do your tax-selling -- as many people do -- following the wash sale rules meant that you couldn't buy back your stocks until January. And given how far stocks rebounded in the interim, you would have had to pay a lot more to get back in:

Source: Yahoo! Finance.

The problem with tax-loss harvesting is that it turns you into a market-timer during that waiting period. But you can take steps to offset that market-timing risk.

Enter ETFs
One solution to the wash-sale rules is to replace the stock you're selling with a similar stock. For instance, in the examples above, you could buy Nucor (NYSE:NUE) at the same time you sell U.S. Steel. As long as the replacement stock moves in tandem with the one you sold, you've solved the problem. But if your replacement stock gets hit with a company-specific problem, suddenly you have an even bigger loss.

The rise of ETFs, however, has created a way to hedge your bets without that risk. For instance, if you had a portfolio that included Macy's and Best Buy, you could replace them with the SPDR S&P Retail ETF (NYSE:XRT) during the waiting period. With a diversified ETF, you'd be much more likely to track the overall industry fairly closely, even if one of its holdings takes a big hit. Yet the ETF doesn't trigger the wash sale rules.

Carrying forward
Once you've locked in your losses, you don't have to worry about using them all right away. Any tax losses that you're not allowed to use in a given year will be carried forward into future years. That means if you have capital gains in the future, you can still use past-year losses to offset them.

That could save you a fortune down the road. And paradoxically, to get maximum benefit from those losses, you want to take them before stocks recover -- because then you'll have the biggest losses you could.

So if you don't want next year to be a repeat of this year's tax debacle, get started now on cutting future taxes. With smart tax-loss harvesting, you can turn last year's pain into tax benefits for years to come.

For more on dealing with gains and losses, read:

• Oh no! Your stocks have surged!
• Stop buying these stocks.
• Some stocks benefit from disaster.