Americans usually focus on taxes in the weeks leading up to April 15.
However, December is also a good time for tending to some tax-related items, as Dec. 31 is the deadline to complete many tasks that result in a tax deduction. It’s easy to remember that date when it comes to fairly simple actions, such as cleaning out the closet and donating clothes to Goodwill or the Salvation Army. But some year-end tax-related tasks are a little tougher to focus on.
Tax-loss harvesting is one such item. It comes up a lot in tax-savings checklists, but its name can obfuscate its purpose.
The concept itself is fairly simple: If one of your investments is showing a loss, you may sell that security to offset taxable gains in other investments. This applies to single stocks, bonds and funds.
“Realized losses are able to offset gains and in some cases, a portion of income. The concept is that you sell a security at a loss and immediately replace it with a similar one while maintaining the appropriate asset allocation,” says Dave Geibel, senior vice president and wealth advisor at Girard Partners in Philadelphia.
While a discussion of taxes is not at the top of most Americans’ list of fun things to do, it’s something investors shouldn’t avoid.
“We usually begin the conversation by saying, ‘It isn’t what you make on your investments and earnings that’s important. It’s what you keep.'” says Mike Tedone, partner at Connecticut Wealth Management in Farmington, Connecticut.
“When we explain difficult concepts to clients, we try to stay away from jargon and instead use everyday language. We also are very visual in the way we discuss topics. We use 60-inch touch-screen monitors that double as white boards. We show how the numbers work and, at the end of the day, how much money our tax management strategies saved them in dollars and cents,” Tedone says.
The mechanics of tax-loss harvesting. “Tax-loss harvesting can be an effective strategy for advisors and clients to minimize their tax liability,” says Stein Olavsrud, a certified financial planner and portfolio manager with FBB Capital Partners in Bethesda, Maryland.
But investors should be aware of certain rules and potential snares. For starters, realized losses can offset gains and reduce ordinary income up to $3,000 per year.
In addition, an investor’s capital gains rate is a consideration. “Traditional planning used to be relatively straightforward, as the maximum capital gains rates were uniform for all investors,” Olavsrud says. “However, the introduction of the 20 percent long-term capital gains tax rate and a 3.8 percent Medicare surtax complicates things significantly. There are now four capital gains brackets, depending on one’s income.”
These range from zero to 20 percent, plus the Medicare surtax.
Given these various capital gains brackets, Olavsrud recommends that investors work closely with their financial advisors and tax professionals to best understand how gains or losses may affect them this year and in the future.
“For one investor, it may be prudent to utilize losses to offset gains, but for another investor, it may be more prudent to advance gains to take advantage of the 0 percent or 15 percent tax brackets. Make sure you have a solid grasp on how the various brackets work prior to assuming that you should be seeking to offset gains with losses,” he says.
Avoiding wash sales. When selling a security at a loss and replacing it with something similar, investors must not run afoul of the Internal Revenue Service’s wash sale rules. These were put in place in 1921, and the intention remains the same today: The IRS does not allow investors to claim a tax benefit from the sale of a security on Dec. 31, and then buy back the exact same security on Jan. 2.
Investors wishing to maintain certain portfolio allocations must take care that they don’t replace the security they sold with one that the IRS deems “substantially identical” within 30 days before or after the sale.
“In this case, the amount of the loss will not be deductible, and instead will be added to the basis of the new position,” says Thomas Mayper, executive vice president at RDM Financial Group in Westport, Connecticut.
Substantially identical positions include options to buy the same security that was sold. In addition, the wash sale rule applies to multiple accounts held by a taxpayer, as well as his or her spouse.
Another thing to be aware of: Investors cannot simply shuffle around the same holdings in their taxable and qualified vehicles, such as individual retirement accounts. “You cannot sell the security in one account and buy it in another without incurring a wash sale,” Mayper says.
Geibel offers an example of transactions that would provide the benefits of tax-loss harvesting without triggering the wash-sale rule.
“You own Chevron (ticker: CVX) and lost money this year as oil prices have slumped. You can sell Chevron at a capital loss and simultaneously buy Exxon Mobil (XOM), which is a similar company and highly correlated with Chevron. If oil prices recover, so will your position. You’ll book your tax loss to offset gains for the year, thereby reducing tax liability and not changing the construct of the portfolio,” he says.
Who should use tax-loss harvesting? Although investors in higher brackets have more concerns about the taxes’ effects on portfolio returns, financial planners recommend that all investors understand the potential benefits of tax-loss harvesting.
“It’s important for investors to know that after-tax returns matter,” Geibel says. “If your portfolio’s total return for the year is 6 percent, but you generated an enormous amount of capital gains, the real after-tax return can be substantially less than 6 percent because you have to pay taxes on the gains. Managing taxes each year should be part of the overall strategy in non-IRA or non-qualified accounts.”
Tedone frames the potential tax-savings in terms of real dollars and what they can buy. “We think everyone should be paying attention. If we can save a client $100 in taxes, that’s dinner with his or her spouse that we just paid for. Who doesn’t appreciate a free meal?”
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Why Tax-Loss Harvesting Is Important for Investors originally appeared on usnews.com
