With the end of the year coming, investors should look at strategies like harvesting tax losses and trimming stock holdings that have grown too big thanks to this year’s run-up.
Though you can trim this year’s tax bill by selling losing investments as late as Dec. 29, the year’s last trading day, it’s easy to get behind during the holidays or to miss an opportunity as market conditions change.
Ideally, harvesting losses and rebalancing a portfolio should be done at the same time, experts say, so it’s best to leave plenty of time to figure out what to do.
The Modern Wealth Index survey of investor behavior, conducted regularly by Charles Schwab, the brokerage, show that less than 40 percent of investors have rebalanced their portfolio in the last year, says Rob Williams, the firm’s director of income planning.
[See: 10 Stocks That Oppenheimer Analysts Adore.]
“With U.S. large [company stocks] up 16 percent, the financial and health care sectors’ strong performance, and international markets up more than 20 percent this year, investment portfolios can stray from their original allocation and be much riskier than people realize,” Williams says.
“End of year is a good time to take a look at your portfolio allocation and make sure it’s aligned to your goals and risk tolerance,” he says. “This can be especially important for people nearing or in retirement who might not be able to withstand any sudden volatility.”
Tax-loss sales involve selling stocks, bonds or funds that have fallen in value since they were purchased. The losses are subtracted from any gains booked on other investments that were sold, reducing long- or short-term capital gains tax. And if losses exceed gains, they can be used to reduce ordinary taxable income by up to $3,000 a year. Losses beyond that can be carried forward to offset future capital gains or income.
“Tax loss harvesting is an underappreciated investing strategy, Williams says. “Investors generally don’t want to sell anything at a loss, but there can be a significant advantage if you have gains to offset. Tax loss harvesting can also serve as a motivation to sell underperforming investments or re-diversify overly-concentrated stock positions.”
While the idea seems pretty straightforward, it can be tricky to do. It would not make sense, for example, to sell a losing investment if you thought it was about to rebound, since new gains could well be worth more than the tax benefit from dumping a loser. So selling takes the same analysis as buying.
In fact, it may make sense to also sell any winners you think are poised to sink. Look through all your holdings and ask of each one: “Regardless of how it has done in the past, would I buy it today?” If the answer is yes, keep it; if no, sell.
To further complicate matters, you may have some holdings built up over time with shares purchased at different prices, making some shares winners and others losers. If you generally like this investment, you could sell only the money-losing shares to book the losses.
Again, this should not be left to the last minute because your broker or fund company may have special requirements, like asking that orders describe exactly which blocks of shares to sell. Check with the firm before just issuing orders online. You can’t just tell the IRS you sold the biggest money-losing block of shares unless you’d specifically told your broker or fund company to sell that block.
Of course, tax-loss sales generate cash that must be put to work. You could simply build up another investment you have already, or find something new. But should you pour all that cash into a new holding all at once?
[See: 8 Ways to Satisfy a Craving for Restaurant Stocks.]
Daniel Kern, chief investment officer at TFC Financial Management in Boston, suggests dollar-cost averaging over time. That calls for putting equal sums into a given investment every month or quarter, so that you get more shares when prices are low, fewer when they are high. This reduces the risk of buying everything at the peak, and it can reduce the average price you pay per share over time.
“I’ll admit to being nervous about the market,” Kern says. “I think the economic expansion and bull market in equities has more room to run, but think that there is an elevated risk of a near-term stock market correction.”
As mentioned, tax moves should be part of a broader strategy of keeping proper asset allocation in your portfolio. If you started the year on target with a plan calling for 60 percent stocks, 30 percent bonds and 10 percent cash, you may be overweight in stocks, since they’ve had such a strong year. So this would be a good time to rebalance by shifting money from stocks to bonds.
“If you allow your portfolio to simply follow the market and never or very infrequently rebalance, you will end up with high allocations to assets that have done well recently, and low allocations to investments that have performed poorly recently,” says Anthony D. Criscuolo, portfolio manager with Palisades Hudson Financial Group in Fort Lauderdale, Florida.
“However, investments tend to revert to the mean, meaning investment returns will revert to their long-term average or expected return over long holding periods,” he says. “So if you sell your recent winners and buy more of the recent losers, over time this rebalancing will lead to superior long-term results. You are selling high and buying low, while not necessarily exactly at the top or bottom.”
Rebalancing to target allocations, assumes, that your plan still makes sense. Many investors choose to become more conservative as they age, and your willingness to take risk can change with other factors such as changing jobs or losing one, starting a family or seeing your kids leave home. The rebalancing process should therefore begin with a review of the long-term plan, and setting new allocation targets if necessary.
Selling winners in taxable accounts can trigger capital gains tax, but the hit can be minimized by selling within tax-favored accounts like IRAs and 401(k)s.
[See: 7 Best Dividend Stocks to Buy for the Rest of 2017.]
So long as your portfolio meets your asset-allocation plan, it may not be necessary that every account hit the target. Remember, though, that it may be wise to have different allocations in accounts earmarked for different purposes, such as college costs coming soon versus retirement still years away.
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Prepare Now to Harvest Tax Losses originally appeared on usnews.com
