There’s been plenty of talk this year about potential revisions to the tax code, many of which carry implications for investors, particularly those in higher tax brackets.
New tax proposals aren’t yet law, but with year-end drawing near, advisors have opportunity to discuss with clients the strategy known as tax-loss harvesting. The premise of tax-loss harvesting is easily conveyed to clients. In this scenario, an investors sells a security, like a stock or an exchange traded fund, that’s a losing position and uses that loss to offset some of the capital gains on a profitable position.
Tax-loss harvesting can be particularly advantageous for investors involved with actively managed mutual funds, which frequently pass on capital gains expenses to investors, regardless of whether or not the investor sold part or all of a winning position.
“But what if you have something in your portfolio, like a stock or a fund, that has lost value during the year? If you decide to use tax-loss harvesting, you would sell this investment and take the ‘loss,’” says Michael Barrer, WisdomTree director of Capital Markets. “The loss offsets your portfolio’s short- or long-term capital gains, lowering the amount you will be taxed on. And, of course, you have the option of reinvesting the cash from the sale in some other way.”
Obviously, no investor likes taking a loss, let alone a big one, but if a loss is large enough, it can go a long way towards reducing tax obligations on profitable trades.
“Imagine you invested $20,000 at the beginning of the year in security X. But toward the end of the year, security X is down by 10% and is worth $18,000. What can you do?” Barrer hypothesizes. “First, you could just hold on to the security. Second, you could sell the security, take the $2,000 loss, deduct that loss from your taxable income, and pocket the remaining cash. Third, you could sell the security, take the loss and the deduction, while reinvesting your proceeds in a different security.”
As Barrer notes, by selling that security, an investor in the 37% tax bracket could save $740. That’s nothing to scoff at. Another option is to sell that dud investment and buy something, thereby remaining involved in the market while still realizing a tax break.
For clients with questions about the wash sale rule, advisors can tell them that they can ditch a mutual fund for an ETF and not risk running afoul of IRS rules.
“It’s worth noting that ETFs are not currently considered substantially identical to mutual funds. You may be able to use this fact to maintain your investment exposure, while still capturing losses for tax purposes,” concludes Barrer. “The bottom line is that tax-loss harvesting can help you manage your investment losses.”
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.