When the stock market goes down, investors get frustrated. But there is an upside in an otherwise gloomy situation. It's called tax-loss harvesting. You can use this strategy to increase your overall returns, especially in your earlier years of investing.

An Example of Tax-Loss Harvesting

Imagine that on the first day of any given year, you invest $10,000 in stocks via an exchange-traded fund (ETF) such as the SPDR S&P 500.

Let's assume this ETF trades off by 10% to a market value of $9,000.

Rather than feeling sorry for yourself, you can sell the ETF and reinvest the remaining $9,000 back into the stock market.

You are keeping your market exposure constant. Yet, for IRS tax purposes, you just realized a loss of $1,000.

You can use this loss to offset your taxable income, giving you incremental tax savings or even a bigger refund. Since you kept your market exposure constant, there has been no change in your investment cash flow, just a potential cash benefit to record on your tax return

Now let's say that the market reverses course and heads north. Your new investment surpasses even that initial investment of $10,000 and closes out the year at $10,800, yielding a 10% pretax return after adding in the typical 2% dividend yield.

The Numbers

Had you done nothing except buy-and-hold in the above scenario, you would have an after-tax return of 9.4%, represented by an 8% unrealized investment gain plus a gain of about 1.4% dividend gain, even assuming you were in the highest 24% tax rate for 2018.

However, if you had sold your first, losing investment and bought more stock with the proceeds, you would also have a loss of $1,000 to offset some ordinary income or other taxable gains you were reporting. At the top tax rate, this would be worth $760 in income tax savings. That adds up to another 7.6% return on the original $10,000 investment. Thus, your net-net after-tax return would now be 16.6% (9% + 7.6%).

Limitations on Loss Harvesting

There are some limits on this activity.

IRS Regulations: The IRS won't let you buy an asset and sell it solely for the purpose of paying less taxes. Thus, on Schedule D of the 1040 tax form, the loss will be disallowed if the same or a substantially identical asset is purchased within 30 days. This is called the "wash-sale rule."

Income Threshold: Up to $3,000 of loss can be used to reduce your taxable income, or $1,500 each if married filing separately. However, the additional tax loss may be carried forward for use on future tax returns. 

Growing Portfolio: Realizing tax losses lowers your tax basis, which makes harvesting harder to do the longer the portfolio grows. In any case, getting this tax benefit up front is best for most investors. 

Administrative Cost: Making a transaction every time the market goes down can be onerous from a tax-preparation standpoint. A general rule to use is that you should harvest the loss if the tax benefit outweighs the administrative cost. 

The Bottom Line

Tax-loss harvesting is a strategy that is based on an opportunity created by tax law, not on market speculation. In some cases, after-tax returns could be greatly enhanced, putting the investor well on the road to quicker asset accumulation. So don't feel blue next time the market turns downward.