Most of us live here in New England because we love the change of seasons. It's always bittersweet when we bundle up for those last few trips to our farmer's markets, become tourists ourselves of the spectacularly colorful transformations of our hillsides, and finally wait for that first snowfall. Our farmer friends are in the process of gathering their final crops and putting their fields to bed. We too should be considering our own harvest...... tax loss that is.
Whether you manage your own portfolio or have a financial advisor, you know that every investment you pick is not going to be a winner. Companies disappoint, economies disappoint, stocks and funds go up and down in the process. When your funds are done, what can you do about it?
First, if it is an investment that you like and you believe will recover you could choose to hold it or even buy more. If you choose to sell it permanently, you realize a loss and a tax break. You can deduct up to $3000 of long term net losses against your taxable income. Or you can tax loss harvest.
Tax loss harvesting is the process of selling a security that has experienced a loss and replacing it with a similar one, maintaining your original investment strategy enhanced by tax savings. Said another way, in this strategy you have both the benefit of a tax loss that can be taken against other investment gains or taxable income and your original investment strategy. (Example, a $10,000 loss could shelter $7000 of investment gains and $3000 of taxable income) If your tax bracket was 33% your tax savings would be $1000. If the market then reverses and heads north, all returns being equal, you have preserved your returns through your new investment enhanced by your tax savings. You returns have been enhanced by tax law not just market speculation.
There are limitations. First the IRS will not just allow you to buy and sell securities simply to take advantage of tax losses. The "wash sale" rules state that the loss will be disallowed if a substantially identical asset is purchased within 30 days.
Most investors would not want to be out of the market for 30 days. In that case you could purchase a highly correlated investment, one that moves similarly, to replace that one that you sold, for example a large cap mutual fund to replace your S&P 500 index fund.
Another limitation is the income limitation. Only $3000 can be used to reduce your taxable income. But if you have gains in other areas of your portfolio, these losses can be used to offset those gains and excess losses can be carried forward for use against taxable income in future years.
Realizing these losses does reduce your basis in your investment so that if the market continues to travel north you may ultimately pay the tax piper but the value of your tax savings may have a greater value to you today.
Keep in mind these losses are only valuable to you in your after tax accounts. Retirement accounts, IRA and Roth accounts are already tax preferred and any losses realized in those accounts will not create this tax advantage.
Finally, we have to be aware of the cost of buying and selling Care should be taken to review the tax savings against any cost of selling and buying to make this happen.In summary, there is a bright spot in market fluctuations, one created by tax law. A timely review of your portfolio for loss opportunities may enhance investment returns in your portfolio. Research has shown that these enhancements could be as much as .5% to 1%. Over a long period of time these additional dollars earned are not shabby.