Making a Profit from a Market Loss

Last Updated Jul 1, 2010 12:29 PM EDT

The market adage says you need to "buy low and sell high" but every once in a while, taking a loss to "sell low" is a pretty smart idea. Now, as the market is in the midst of a summer swoon, might be just the time to do it.

Why would you want to sell now? To collect a tax loss that could prove valuable later. If you sell and buy back shares that are similar to the ones you sold, you risk nothing to a potential market rebound, but you gain tax losses that can offset future income. That's worth at least $15,000 for every $100,000 in losses that you trigger -- and it could be worth considerably more.

You need two things to engage in this strategy: Investments in taxable accounts and mutual funds.

If you only have investments in tax deferred retirement accounts, such as 401(k)s and IRAs, stop reading. Triggering losses in these accounts will do you no good. You don't have to pay capital gains when you sell at a profit within these accounts but you also don't get the benefit of being able to claim capital losses.

It also won't work if you only own individual stocks in companies that you like. That's because you can't repurchase their shares immediately without running afoul of so-called "wash sale" rules. The IRS essentially bars you from claiming a loss on a security you sell if you buy a "substantially identical" security within 31 days. Could you sell the stock and buy it back in 35 days? Sure. But that's risky. If the stock soared during that time frame, you would have lost out on real profits to trigger a paper loss and that would be stupid.

But if you have mutual funds in a taxable portfolio, you can use market drops like this one to make strategic changes in your portfolio that put you in a better position long-term, while not significantly changing your mix of assets.

How so? Let's say that you bought $100,000 worth of Vanguard's Total Market Index Fund three years ago. Thanks to the really rotten performance of U.S. stocks over that time period, your fund has lost an average of 9.24% per year.That's left you with $74,762 in invested assets and a $25,237 unrealized loss. If you sell those shares, you trigger the loss. But since you don't want to change the stocks in your portfolio, you immediate buy Vanguard's Total Market ETF (that stands for "Exchange Traded Fund.")

Why wouldn't that be a wash sale? Because the Total Market Index Fund has annual expenses of 0.18% each year, while the ETF charges just 0.07%. That smaller fee means that, even with the same stocks in your portfolio, you're going to earn a slightly better return. Instead of losing 9.24% on average over the last few years, for example, this fund has only lost 9.16%.

You may scoff at that incremental difference, but if you've got a long time to invest it really adds up. Need proof? Let's assume returns eventually turn positive (heaven help us, if they don't) and the market starts kicking off average annual returns of 10% over the next 30 years. If you're in the Total Market Index Fund, you'll take home a return of 9.82% after deducting the 0.18% fee. If you're in the Total Market ETF, you'll take home 9.93%.

Assuming you invested $100,000 and left it alone for 30 years, your nest-egg would grow to $1.88 million with the index fund, but it would grow to $1.94 million with the ETF simply because of that lower fee. (By the way, you can do the math using BankRate.com's handy Simple Savings Calculator. Just put in the return you expect to earn, minus the fund's fees, and compare.)

The IRS doesn't have bright line rules saying what's a wash sale and what's not when you're dealing with mutual funds, but I would feel quite comfortable explaining why a potential $60,000 bigger profit on the ETF meant that the ETF was a substantially different than the fund that held the same investments.

Meanwhile, this transaction has also triggered some juicy capital losses that will allow you to wipe out some $25,000 in future income. Capital losses can be used to offset capital gains, but if you don't have enough capital gains to use them up, you can write off up to $3,000 a year in losses against ordinary income. Assuming you're in the 28% tax bracket, that saves you $840 a year in federal tax -- even more if you pay state taxes, too.

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