It may be time for tax loss harvesting, but what is that?

Watching your investments take a tumble in the stock market generally isn't a fun experience. But seasoned investors know that market volatility — and the inherent ups and downs that come with it — is a natural part of the process, and that historical trends show that market swings even out over time.

In the right conditions, a market drop can even present opportunities, such as with tax loss harvesting.

If this concept intrigues you — particularly in light of recent stock index declines — here's what you should know:

A potential tax-saving strategy

The tax loss harvesting strategy applies specifically to investments held in taxable accounts. Since current taxes aren't applied to IRAs or workplace retirement plans, this strategy is not applicable in those accounts.

The tax benefit of selling a security in a loss position is that those losses could potentially reduce your tax liability. Suppose you invested $10,000 to buy 1000 shares of a stock for $10 per share more than a year ago. Today, if the stock's value dropped to $8 per share, your initial investment is now valued at $8,000. The stock may recover and eventually appreciate in value. But if you sell it today, you could claim a $2,000 long-term capital loss. Is that the right choice?

The upside of tax-loss selling

One deciding factor is whether you have capital gains that can be offset by the losses you incur from selling securities in a negative position. Long-term capital gains which relate to assets you've held for more than a year are taxed at rates of 0%, 15% or 20% based on your federal taxable income. If you had a $3,000 long-term capital gain to claim on your 2022 tax return, that would come with a federal income tax bill of $450 if your long-term capital gain is taxed at the 15% rate. If, at the same time, you lock in a $3,000 long-term capital loss on a different investment, it will offset that gain and eliminate the tax liability with respect to that capital gain.

Likewise, if you own mutual funds in a taxable account, they may pay out capital gains distributions this year, even if they are not performing well at the present time. Those gains too can be offset by capital losses you claim.

Note that you may not need or want to offset capital gains if your taxable income in 2022, including the gains, is $41,675 or less for single tax filers or a married taxpayer filing separately, or $83,350 or less for a married couple filing a joint return. Taxpayers with total taxable income and gains below those income thresholds qualify for a 0% tax rate on long-term capital gains.

Singles and married couples filing a joint return can use up to $3,000 of net capital losses to offset ordinary income ($1,500 for a married, filing separately, tax filer). Beyond that, unused losses can be carried forward to offset potential taxable capital gains in future tax years.

Cautions about tax loss selling

The downside to selling a position that has suffered a loss is that you can't purchase that specific security or one that is "substantially identical" to it 30 days before or after the sale at a loss without the possibility of running afoul of the wash sale rules and deferring the loss. Choosing to sell also means you sacrifice the potential to benefit from a rebound in the price of the security while you are out of the position. You want to be certain that you are comfortable not owning a specific security for a period of time that could be a candidate for tax loss harvesting.

Most of all, any buy-or-sell decisions you make regarding your portfolio need to go beyond just the tax consequences. Talk to professionals about how tax loss harvesting opportunities fit into your overall financial plan and to understand how tax rules apply.

Shawn Bumgardner is a financial adviser and president of Clear Horizon Wealth Advisors, a private wealth advisory practice of Ameriprise Financial Service Inc., in Southgate. He can be reached at 734-284-3700.