When it comes to portfolios, some things stay the same no matter the generation of investor. At any age people hate losing money and love talking about their winning investments. I’ve practiced in the financial services industry for more than 20 years and I am amazed at how many stories I’ve heard about “the best trade I ever made” or “how much money was made on a once in a lifetime deal.” At the same time, I doubt more than five people have told me about how they lost money in an investment on something they thought was going to be a grand slam.
This psychology of winning and losing mixed with the psychology of money is part of the reason why people do not like to proactively tax loss harvest their portfolios. Yet, this is a critical aspect of portfolio management and shouldn’t be overlooked!
Note: tax loss harvesting only applies to taxable accounts such as individual accounts, joint accounts, trust accounts, custodial accounts, etc. – NOT IRAs, retirement plans at work or other tax deferred accounts.
Here are a few reasons why you need tax loss harvesting.
Offset your gains
Quite often people are afraid of selling certain investments because they have too large of a gain to make selling the position worthwhile. Yet, if you proactively tax loss harvest, you will grab losses when they occur and be able to potentially use them to offset gains you have in your portfolio elsewhere. Everyone’s situation is different, but so often I see people with large gains on older economy stocks that they wish they could sell if not for the massive gains. Well, be fearless selling other investments at a loss and then using that loss to allow a sale in that ancient stock and offset some of that gain.
For example, if the old stock has a $30,000 long-term gain and you hold another investment that has a $2,000 long-term loss, you might consider selling the investment that is down, locking in that loss and then selling enough of the older stock to generate $2,000 of long-term gain. The total taxable gain in that transaction is $0, and now you have a chance to sell your loser, your long-term winner and figure out a better place to invest given the market dynamics right now!
You need to look over your investments!
Not every investment that is at a loss is completely broken. Investments can go down for a variety of reasons. In fact, your investment may be down because the whole market fell, or news about exports to China. Some reasons may be short-term in nature which may mean the reason for owning that investment type still makes sense. Plenty of times you can sell something at a loss and buy something very similar that will hopefully go up the same as the investment you just sold. You need to wait 30 days to comply with IRS wash sale rules before buying the exact same investment back.
In today’s investment world, it’s common to find an index or ETF to invest in to replace the security you are selling that can act as an adequate placeholder. Or it could be the case that you may need to sell one of your investments because it is a poor performer and being proactive for the sake of tax loss harvesting is a good motive!
A tax break for ordinary income
You should know tax loss harvesting could potentially help reduce your ordinary income and the amount you need to pay in taxes. It’s true.
For example, let’s say you recently bought an investment for $10,000 and disaster struck, and it dropped to $7,000 within the first 365 days you owned it. If you sell that investment, you lock in a $3,000 loss. If you still like the investment you own that just went down, buy something similar, just not the same investment because you would run afoul of wash sale rules. Now you have that $3,000 loss that is short-term because you owned that investment less than one year. You can use the $3,000 capital loss from your investment to reduce your taxable income for the current year.
In this example let’s assume that your tax rate is 30%. You could generate a current income tax benefit of up to $900 ($3,000 × 30% = $900). That $900 of tax savings is real money today in your pocket that you can save, grow or spend. If you use this strategy regularly over time it adds up to a lot of money!
Losing money on your investments is never fun. Yet the way to make some of those losses work for you is by being thoughtful and proactive in your tax loss harvesting. If you take advantage of the tax opportunities market movement provides, it could end up improving your personal financial situation.
Michael Carlin, AIF®