Like kingdoms, tides and my teenage daughter’s emotions, the stock market rises and falls. Although market downturns are inevitable and expected, they are never pleasant to experience. On the bright side, these dips present an opportunity to make the proverbial lemonade out of lemons by allowing Uncle Sam to share the pain. This is accomplished through a process called tax-loss harvesting. I will break down this strategy into the three “P”s: principle, process and payoff.
If an investment asset is sold at a gain, capital gains taxes will be owed on the increase in value. For example, if a share of Dunder Mifflin stock is purchased for $100 and later sold for $150, capital gains tax will be owed on the $50 of gain. Investments held for at least a year are taxed at a lower rate than those sold less than a year from the purchase date.
Conversely, the tax code allows assets sold at a loss to offset gains, thereby reducing taxable income. As an extension of the prior example, let’s say that this investor sold shares of Springfield Nuclear at a $30 loss during the same calendar year. This $30 loss would offset the $50 gain, resulting in only $20 of gain between the two sales. If more capital losses than gains are generated in a calendar year, $3,000 can be deducted from ordinary income and the remaining capital loss is carried forward to future tax years. This is known as a tax loss carryforward.
While the concept may not be overly complex, the process for successfully executing a tax-loss harvesting transaction is precise and unforgiving. Special care must be given to ensure that the correct procedures are followed to prevent potentially costly mistakes.
First, you will need to carefully and frequently monitor your portfolio for tax-loss harvesting opportunities. One of the foremost considerations is the benefit of the tax deduction relative to transaction costs. To ensure that the harvest is productive and fruitful, you should establish some parameters such as a dollar loss and minimum percentage. For example, you may opt only to harvest a position if it clears a loss threshold of $5,000 and 5%.
Next, because market losses can reverse quickly, it is important to avoid being out of the stock market. If you purchase a “substantially identical” investment within 30 days before or after the loss sale, this violates what is known as the “wash sale rule” and renders the loss unusable for tax purposes. To avert a wash sale violation, choose a substitute investment that is similar but not “substantially identical”. After 31 days you can reverse the swap back to the original holding. If there is a sizeable gain in the substitute investment during this 30-day period, it may not make sense to trade back to the original position. This underscores the importance of selecting a suitable proxy investment when harvesting losses.
Lastly, while many investors and even some advisors may only check for loss harvesting opportunities at year-end, one must evaluate year-round to fully capitalize on the strategy. This is a critical step because although a portfolio may contain a loss at any given point during the year, the investment could rebound quickly and the window of opportunity would swiftly close.
Following this process amounts to real, tangible tax savings. In addition, tax-loss harvesting may create other planning opportunities and economic benefits. Deductible capital losses come in very handy when faced with future portfolio rebalancing or restructuring and can even be used to offset capital gain distributions from mutual funds. What’s more, lowering your taxable income may open the door to other tax planning strategies, allowing you to manage your lifetime tax bill more effectively.
If this important investment management methodology is missing from your portfolio, there is no better time to start than now. If you do not have the necessary tools or time to implement a robust tax-loss harvesting program, consider working with a qualified advisor who does.
Be fruitful and harvest!
About the author:
As a Buckingham Strategic Wealth advisor, has obtained his Certified Financial Planner™ professional and Certified Kingdom Advisor® designations.
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