Tax Harvesting Tips For Investors
By Kevin Dufficy
Tax harvesting, simply put, is the practice of taking losses in a portfolio for tax purposes. All too often, investors (or their accountants and financial advisors) wait until the very end of the year to worry about the losses that can and should be taken for tax purposes. At the very least, a better way is to practice tax-loss harvesting (and be far more proactive in tax planning in general) throughout the year—not just as the annual clock ticks down.
Before getting into detail about tax-loss harvesting, examine briefly the important connection between taxes and investing. Investing is obviously full of uncertainty, but the taxes you pay on investment gains are one domain over which you do exercise a considerable degree of control.
Generally speaking, investors should focus more on their post-tax returns. Simply put, it is more important to focus on how much of your investment return you are able to keep as compared to how much your investment earns. Keeping track of this may require some effort, but it widely accepted that the tax bite is a significant cost and source of inefficiency in investing.
Consider the case of tax-loss harvesting: the practice of selling securities in the portfolio at a loss and applying those losses to offset realized taxable capital gains (including gains on the sale of property or a business) in your portfolio and even tax liabilities on ordinary income. One way to look at tax-loss harvesting is as an opportunity to embrace market volatility and to share your losses with the government, which, after all, is never shy about asking you to share your profits. Since you have no control over market volatility (i.e., when you incur losses on holdings), you need to be opportunistic throughout the year to maximize the benefit of tax-loss harvesting. In other words, you shouldn't wait until December rolls around.
In effect, by recognizing losses already incurred for tax purposes, you're increasing the amount of net-of-tax money available for investment, and thus increasing the amount of capital working for you. There is more than one tax-loss harvesting strategy, but here is one method to consider. Let's say you have a diversified portfolio of stocks (or mutual funds) with careful thought given to risk exposures. You want to maintain those risk exposures while reaping the tax-loss harvest. You can sell stock A with an embedded capital loss and immediately purchase stock B, an equivalent stock in the same industry and with the same risk exposure (note that due to wash-sale rules, you cannot repurchase stock A for more than 30 days).
Here's a very simple example of the math at work. Let's say an investor purchased a consumer staples stock for $100 a share. The stock falls by 50% to $50. The investor decides to hold it. It doubles in price and returns to $100 a share and the investor then sells it. Result: no gain and no taxes incurred (for the sake of simplicity, we'll ignore commissions in our discussion).
Compare that case to a vigilant investor in the 20% tax bracket (i.e., 15% federal and 5% state tax rates) who practices tax-loss harvesting. When the $100 stock falls to $50, the investor sells it, realizing a $50 loss and reaping a $10 tax benefit ($50 x 20%=$10). The investor reinvests the $60 in an equivalent consumer staples stock. As with the first stock, this one doubles in price, to $120. The investor now sells the stock, booking a capital gain of $60. After paying $12 of taxes [($120-$60) x 20%], the investor now has $108. Compared to the first case of passing up the tax loss opportunity, in this case there is a net gain of $8.
Note that the benefits are even greater at higher tax rates. Suppose the gains are taxed at 40% (35% federal tax and 5% state for short-term losses taken and applied to short-term gains). The tax benefit on the $50 loss increases to $20 ($50 x 40%=$20). Now the investor has $70 to invest in the equivalent consumer staples stock. It doubles to $140 and the capital gain is now $70. After paying $28 of taxes ([($140-$70) x 40%], the investor is left with $112, instead of $108 as under the 20% tax- rate scenario.
Careful, year-round tax planning and a focus on after-tax returns are facets of investing that are often overlooked or under-appreciated. Tax-loss harvesting is but one strategy that investors could deploy throughout the year when market vagaries create opportunity. Tax loss harvesting can be beneficial, but complicated, so you should always consult your financial advisor or accountant.
About Kevin Dufficy
Kevin Dufficy is a seasoned financial expert having written articles and blogs on a wide range of financial, investment and retirement planning topics. He has an MBA from UC Berkeley, and a degree from H.E.C., the leading French business school in Paris, France. To follow Kevin"s profile, click here.