How a Bear Market Can Be a Blessing for Your Tax Bill

Although bear markets are a natural part of the stock market, nobody likes seeing their portfolio decrease in value, even if it's just on paper. You should always focus on the long term, but some moves can be made during down periods to give you some short-term relief. Cutting your tax bill is one of them.

To the surprise of I'm sure not many, Uncle Sam wants his share of your investment profits. The rate you pay on your profits (capital gains) depends on your income and how long you've held the investment. If you hold an investment for less than a year, you'll pay your regular income tax rate. If you hold it for a year or more, you'll owe a more favorable capital gains rate. Here are the 2022 capital gains tax rates:

Capital Gains Rate
$40,400 or less ($80,000 or less if married and filing jointly)
$40,401 to $445,850 ($80,801 to $501,600 if married and filing jointly)
$445,851 or more ($501,601 or more if married and filing jointly)

Data source: IRS.

Tax-loss harvesting

Just as your capital gains add to your tax bill, capital losses can lower your taxable income and offset any capital gains you owe taxes on, up to $3,000. For example, if you sell Stock ABC and make $3,000 in profits and also sell Stock XYZ at a $3,000 loss, they would offset, and you would have no tax implications. If you sold Stock XYZ at a $2,000 loss, you would owe taxes on $1,000 in capital gains. If you sold Stock XYZ for a $4,000 loss, you could deduct $1,000 from your taxable income. This is called tax-loss harvesting.

Image source: Getty Images

During bear markets when prices are dropping, that may be the chance to either offset some of your capital gains for the year or lower your taxable income with some of your losses. While you should always be focused on the long term and not be discouraged into panic selling during bear markets, it's important to know when to cut your losses.

Major indexes and blue-chip stocks tend to survive rough economic periods and produce great long-term returns, but unfortunately, some companies will inevitably not make it through. Sometimes it's better to sell before more damage is done.

If you're sitting on a stock that you believe is on a one-way flight to bankruptcy, it's better to cut your losses early and get a tax break rather than waiting and maybe nothing coming from it.

Wash-sale rule

The wash-sale rule stops investors from selling an investment at a loss and then buying the same investment (or a nearly identical one) within 30 days. This is to avoid a situation in which investors sell for a loss, take the tax write-off, and then buy it right back after they've received the deduction. If you do sell an investment for a loss and buy it back within 30 days, you won't be allowed to deduct the loss. If you had $3,000 in capital gains, sold an investment at a $2,000 loss, and bought it back within 30 days, you'd still owe taxes on the $3,000.

If you're truly selling a stock, it should be because you no longer believe in its long-term potential, not just because you think the tax break will make the sale worth it.

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