The first question to ask yourself is whether there are other investments that are likely to grow faster, or balance your portfolio better, than the ones that you own. Often the answer is yes, and in those cases you should try to sell winners and losers in equal proportions to minimize your tax bill. "You can take the losses today, still remain in the market and use those losses to offset current capital gains," says financial planner Altair Gobo of U.S. Financial Services in Fairfield, N.J.
Remember that with a mutual fund, you could have a capital gain even if your fund is down overall this year. A fund's distribution of capital gains may be based on transactions that its manager made earlier in the year, and those distributions are taxable.
But even if you don't have any winning stocks in this bear-market year--or any that you want to sell--it can make good tax sense to sell at least some of your losers.
First, you should consider taking as much as $3,000 in capital losses--the maximum amount you can use to offset ordinary income. If you're in the 27.5% tax bracket, this move can save you $825--or more if your state offers deductions.
Next you should consider taking losses this year that you can use to offset future capital gains. Afraid to sell for fear the stock or fund will come roaring back? You can always record the loss and then buy back the same security 31 days later without violating the irs's "wash-sale" rule. You can also sell a security from your taxable account and then immediately purchase the same security in your tax-sheltered IRA or 401(k) account, says Martin Nissenbaum, Ernst & Young's national director of personal income tax planning.
If you want to keep the same asset allocation in your taxable account, consider selling a security at a loss and buying back a similar holding right away. Here's one way to do it: say your favorite computer stock lost more than half its value this year; you can sell it and then immediately buy shares in another computer company or in a technology mutual fund.
Harvesting losses with a mutual fund is a little easier. Let's say you purchased $10,000 of a large-cap growth fund, and now, with the market's slide, the fund is worth less than $7,600--a likely scenario, considering that the average large-cap growth fund is down more than 24% this year to date. You could sell the large-cap growth fund and invest the money in another fund family's large-cap growth fund. Because the funds will probably have similar holdings, you won't alter your asset-class mix, and your investment strategy stays intact.
Harvesting losses does pose some risks. If you decide to take a loss now and don't buy a similar stock or fund right away, you might miss out on the run-up as that market sector or industry recovers. Also, "if you swap out of one asset, and you take a loss and reinvest the money in another asset, you're taking a different kind of risk," says portfolio manager Josh Weiss of Litman/Gregory Asset Management. "Even though you may be swapping into something similar, it doesn't guarantee the performance will be identical."
So weigh the tax benefits and investment risks before joining the harvest. If your losses are large, you may be able to sell a security without altering your investment strategy.
The holiday season is the time when people usually give thanks for how much they have received. But with the market's decline this year, you can also be grateful for smart ways to cut your losses.
Sharon Epperson is a correspondent for cnbc Business News. E-mail her at firstname.lastname@example.org