Investors have been known to make a mad dash toward the end of the calendar year in hopes of tax-loss harvesting to offset capital gains obligations. You can claim up to $3,000 per year in capital losses, so seeking to limit your tax bill makes financial sense. But it’s all too easy to make costly mistakes when selling securities against a fast-approaching deadline.
In these final days of 2018, take a moment to review your overall financial plan before committing to these kinds of transactions. Above all else, refrain from letting a desire to avoid capital gains taxes sabotage your investment strategy. Next, take care that you don’t violate IRS rules on cost basis and wash sales. Finally, set yourself up in 2019 for a steady and disciplined process for tax-loss harvesting instead of succumbing to a last-minute rush.
At any given point in time you may have investments that are underperforming but which you’d like to keep in your portfolio because you believe in them over the long term. Usually that’s because they have a strong potential to rebound down the line. Those holdings also might serve as “portfolio diversifiers,” without which you could be exposing yourself to much greater downside risk when market conditions shift.
[See: 10 of the Best Stocks to Buy for 2019.]
For example, if your investment strategy calls for assuming moderate risk with a 65 to 35 equity-to-bond split that favors U.S. securities but includes a significant emerging markets component, you need a better reason for selling your EM index fund than that it would counter some of the gains you made by selling bitcoin earlier this year.
Compromising your investment strategy that way can hinder your broader financial plan. It becomes much harder to save for and live comfortably in retirement — as well as to pass on wealth to heirs — if your portfolio never reaches its full potential due to unnecessary and misguided trading.
Provided you are selling securities in accordance with your investment strategy and long-term financial plan, make sure you also meet IRS requirements for reporting capital gains and losses. The more transactions you make over the greater number of accounts, and the shorter the time frame involved, the likelier that errors can arise.
A common misstep is using the wrong cost basis for securities. It’s often most accurate — and therefore safest from the perspective of the IRS — to use the actual purchase price of each share. Many investors use the average cost method when selling mutual funds that hold shares of the same security purchased at different prices. Sloppy record-keeping can derail either approach, leading to higher tax payments or IRS penalties for reporting a false cost basis that would suggest greater capital losses.
[See: 11 Steps to Make a Million With Your 401(k).]
The IRS typically does not allow capital losses reported through wash sales, which occur when you sell a security at a loss and within 30 days before or after that transaction you acquire an identical security or even an option to buy one. Investors can trip up in multiple ways here.
First, the window is 61 days — not 30 days — and it includes the day of the transaction. Second, “substantially identical” is up to the IRS to decide, so choose clearly different securities when transacting within that window. Third, if your spouse is also buying such shares within the window, or if such a transaction occurs inside one of your IRAs, or even if an automated investment tool like a robo advisor that you have money with does so, a wash sale can result.
Now that some aspects of tax-loss harvesting are clearer, here’s what you can do in 2019 to make the most of capital losses. The most important step is to regularly rebalance your portfolio. Some investors prefer to rebalance only once a year, others twice a year, and still others opt for quarterly rebalancing. Whatever path you choose, remember that there are trading costs associated with buying and selling securities to shift the weightings of a portfolio.
It’s also a good idea to keep your portfolio from getting overly complex. While diversifying your investments — which it should be noted neither guarantees profits nor ensures that you won’t experience a loss — could allow you to better withstand market gyrations, that strategy works best when each investment serves a specific purpose, whether it’s exposure to Europe or perhaps real estate. That level of simplicity makes it easier to know what’s worth selling and what’s worth keeping depending on the circumstances.
[See: 10 Reasons Warren Buffett Is a Better Investor Than You.]
Finally — and here’s the most important part — be sure to consult with a financial advisor, tax advisor or both before you make any decision. They are the experts, and no amount of research will likely equip you with the knowledge or expertise needed to ensure that your investments, tax strategy and financial plan are aligned.
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Avoid These Last-Minute Tax-Loss Harvesting Mistakes originally appeared on usnews.com
