The holiday season is now in full swing. So what better time for a discussion about your potential 2019 tax bill. Or more appropriately, how to avoid paying additional taxes. We will assume most investors would rather pay less in taxes than more.
“Tax Loss Harvesting” is a simple strategy that can be applied within the portfolio to help save you some of your hard-earned money. This strategy is an effective way to both offset gains and reduce or eliminate laggard positions within your taxable portfolio before 2019 begins.
Your end of the year tax planning must include a discussion regarding any unrealized gains or losses hiding within your taxable accounts. We will center the discussion around mutual funds, individual stocks, and exchange-traded funds (ETF’s) since these investments are the most widely used.
What is “Tax Loss Harvesting”?
First, tax loss harvesting is a concept that only applies to taxable accounts. This concept will not apply to your non-taxable retirement accounts.
Second, you are selling stocks, ETF’s or mutual funds that you currently have a loss in. You harvest the loss by selling the security for less than you paid for it.
Third, should you want to maintain your current exposure to whatever you just sold, you will need to make a subsequent purchase. You cannot buy back the same security that you sold until 30 days have passed. This is known as the “wash rule.”
No, the investment police will not come through your computer and stop you from buying the same stock you just sold but, should the IRS audit you, they will certainly disallow your loss.
Your brokerage firm may account for any wash sales on your year-end 1099 as well. You will need to buy something new!
Why Should We Do This, It Sounds Complicated?
There are a couple of good reasons to go through the time and effort to complete the tax loss harvesting exercise.
First, you can use losses to offset current gains. If you have sold off some of your investments for gain throughout the year and you do not want to pay some or all the capital gain, you can sell the losses within your portfolio, which will lessen or eliminate the tax bill.
Second, you can pool your losses to offset future capital gains. For example, in the scenario described above, after you sold the investments within your portfolio that had a loss, you ended up with more losses than gains. What happens to the leftover losses? Losses can be pooled and used later to offset future gains.
Tax loss harvesting is an important part of any investment strategy. It is also one of the key benefits of investing outside of a retirement account. Tax loss harvesting is a prudent investment strategy that allows you to keep more of what you make. Let’s take a look at an example to help clarify what we have just discussed.
A Traditional Scenario
In some years finding losses to harvest is easier than others. However, given the recent volatility in the market, there is no shortage of stocks that are in negative territory for the year or down a considerable amount from their record high.
We will start with the following assumptions:
- You own stock and are considering selling it for a loss.
- The stock is a substantial component of an ETF (Exchange- Traded Fund) or mutual fund.
For example, the top holding in SPY, an S&P 500 Index ETF, is Apple. Apple has fallen more than 20% from its recent high price.
I know for many people, Apple can do no wrong! Therefore, let’s assume you would like to maintain exposure to Apple. If this is the case, why not consider selling the stock to realize a loss, “harvest” the tax write-off, and then use the proceeds to replace this exposure with an ETF (SPY). Or you could run a search for the ETF’s with the largest exposure to Apple and buy from the search result. Another option would be to commit heresy and buy Microsoft.
The idea is to immediately re-deploy the cash, maintaining similar overall risk exposure, without having to wait for the 30-day wash-sale window to expire to buy back the same stock you just sold.
If you would prefer to own Apple over the ETF or an alternate stock, then simply sell the ETF/stock in 30 days when the wash rule expires. Use the sale proceeds to repurchase your position in Apple.
The Tax Bomb – Another Reason to Dislike Mutual Funds
Many investors use mutual funds which come with a potential built-in tax bomb known as embedded capital gains. This tax bomb is another reason in the long list of many why we try to avoid mutual funds altogether. For the mutual fund owners out there, the end of the year requires some effort on your part. A lack of effort could cost you a lot of money.
What Causes Embedded Gains Within a Mutual Fund?
Mutual funds must distribute all their realized capital gains or in other words the profits from the sale of stocks sold within the fund throughout the year. Sometimes the sale of stocks within the fund occurs because the manager wants to reposition the portfolio, hoping for better growth. Another reason is to cover redemptions.
Yes, often the shareholders are their own worst enemy. In years like 2018 where investors have run to the exits, generally at the same time, there is not enough cash available to cover the distribution requests. Therefore, the manager is forced to sell stocks to cover the requests.
The more distribution requests, the less efficient the manager can be with selling the stock selection. The manager will eventually have to sell stocks with capital gains. The capital gains are passed on to the remaining shareholders. The fewer shareholders, the higher the percentage of the tax paid by each remaining shareholder.
Don’t be the last one out of a Ponzi scheme. The pigs get fat where the hogs get slaughtered!
Buyer Beware at the End of the Year
You need to find out the date that all remaining owners will share in the embedded gains. To avoid having to pay this cost, you must sell the mutual funds before the declaration date. Should you purchase shares of a mutual fund during December make sure you know if the mutual fund will have embedded capital gains. There is nothing worse than receiving none of the benefits of growth but having to share in the tax cost.
Anyone who has long held stocks in their portfolio today most likely has at least one optimistic vein in their body and may not want to sell because they know/hope/pray that their stock will improve along with the broader market. The good news is there is some historical precedent for that.
Knowing how difficult the psychology of selling losers is for many of you, harvesting losses may be a terrible exercise. Many individual investors will sell winners with little thought other than, “Yes, I won!” These same investors will hold on to losses far too long because they think selling a loser admits defeat.
At Hayden Royal of Wilmington, we try to live by the saying “Let your winners run and sell your losers.” This psychology helps with tax loss harvesting because we do not mind selling a stock especially if the loss is realized for our benefit – paying less in taxes.