Taking The Fear Out Of Lump Sum Investing With Tax Loss Harvesting

Since the last podcast episode with JL Collins, I’ve received a lot of email questions asking about lump-sum investing.  I’m thrilled about these questions because it means the show sparked interest in investing.  From the questions I’ve received, there seems to be a common trend.

Many people are hesitant to invest a lump sum of money because of fear that the market will plunge soon after.  A lot of the questions are similar to:

If I have an “x” amount of money, should I lump sum or dollar cost average into the market?

This is a great question and one I struggled to answer for a while.  So in this article, I’m going to show you what I would do in those situations and how you can benefit regardless of the direction of the market.

We will do this by reviewing two main concepts market timing and tax loss harvesting.  Let’s start with market timing…

 

Market Timing

Market timing is when an investor tries to predict short-term fluctuations in the market and buy or sell investments based on this prediction.  The first step to handling the fear of lump-sum investing is understanding that it’s a fool’s game to try to time the market.

Timing the market involves A LOT of work, research, and skill.  Even after all that, most people would have better returns simply investing in a low-cost passive index fund.  There are several reasons why you probably won’t be able to time the market.

 

Why You Can’t Time The Market

1. You Have To Be Right Twice (Buying & Selling)
2. Efficient Market Hypothesis (Asset Prices Reflect All Available Information)
3. Investor Behavior Based On Emotion (Greed or Fear)

 

At this point, I believe there are only certain people in this world that can accurately time the market but those people are very few and far between.  You are probably not one of those people, sorry to burst your bubble.

However, you can still make great returns with a buy-and-hold strategy and low-cost index funds!

During my interview with JL Collins, he mentioned the stock market goes up on average 3 out of 4 years.  We don’t know which year will be an up year but over the long term, the market goes up more than it goes down.

 

So get your money into the stock market as soon as you can and just forget about it.  It takes almost none of your time to maintain.  So instead of devoting hours to research, you can free up your time for more important things like family, hobbies, exercise, or starting a business.

Easier said than done I know but this is the best answer in my opinion.

So now that we know why we shouldn’t try to time the market we can start answering the question above.  Here it is again:

If I have an “x” amount of money, should I lump sum or dollar cost average into the market?

Answer: Lump Sum Invest!

If your emotions are still getting the best of you, you can read and download my Recession Investment Plan.  It helps you develop a plan to get your money into a volatile market at a rate that makes you comfortable.  Keep in mind the investment plan isn’t the best option.  The best option is again to invest it all as soon as possible.

What the investment plan can help you with is to avoid the anxiety and fear that can accompany lump-sum investing.

I’m now also going to show you how you can use tax-loss harvesting to benefit you if the market happens to crash right after you invested the money.

 

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Tax Loss Harvesting

The best way to describe tax-loss harvesting is when you sell an investment at a loss to offset ordinary or capital gains tax.  It’s a strategy that allows you to take advantage of downturns in the market.  Let’s quickly go over an example to show you how we can use it to our advantage after lump-sum investing.

 

Let’s say an index fund has a price of $100 per share and you invest $100,000 for a total of 1000 shares.

Unfortunately, the index fund price then drops to $70 over the next few months.  Even though you made the right decision, your investment is now worth $70,000. ($70 x 1000)

Not ideal, but you can then sell your shares at the price of $70 and immediately purchase a similar, but not “substantially identical” fund.  By doing this you lock in a loss of $30,000.  Which you can use to offset ordinary income tax or capital gains.

The best part is the “loss” is only procedural because you immediately put that money back into the market to take advantage of future market gains.  This is the best of both worlds.  You pay fewer taxes on future income or gains and you stay invested to take advantage of compounding interest.

With $30,000 in tax-loss harvesting, you can offset $30,000 in capital gains or offset $3,000 each year from your ordinary income for the next 10 years!  Just make sure you don’t break the wash sale rule.

For someone in the 24% tax bracket, offsetting $3,000 a year of ordinary tax results in $720 of tax savings each year.  Over 10 years that is a total tax savings of $7,200!

This is why I see a market downturn as a great opportunity to tax loss harvest and buy more investments.

Eventually, the market will go back up and you will be happy you took advantage.

 

Conclusion

The most important part of investing is getting your money into the market so that it can start working for you.  Since we can’t predict the future it’s best to invest the money you want to invest right away.  Chances are the market will go higher from there and you can enjoy the gains.  If the market goes down you can enjoy the tax savings from tax-loss harvesting.  Either way, you’re a winner!

Important to note this only applies to taxable accounts.  It doesn’t apply to 401k retirement accounts because by default most people are dollar-cost averaging into those accounts with each paycheck.  Also, these accounts are tax-advantaged meaning you can buy and sell within them without having to worry about taxes.

Lastly, for tax-advantaged accounts, your goal should be long-term investing.  From the chart above you can see the market has a strong track record of going higher!

Thank you for the questions and let me know if I missed anything.

 

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