The markets have been hot for a while, and you’ve likely experienced some significant gains in your portfolio. What options do you have to minimize the taxes associated with those gains? Today, an expert weighs in with an excellent overview of Tax-Loss Harvesting. It’s an important concept to understand, and I know of no one better to explain it than Bob French, Director of Investment Analysis at Retirement Researcher (founded by Wade Pfau).
When Bob speaks, people listen. I encourage you to read his overview of tax-loss harvesting, it’s a tool you should understand as you seek to reap some of the gains you’ve made over the past few years. I appreciate experts being willing to help teach investment lessons to the readers, and I’m humble enough to say that I learned some things by reading the words that follow. Hopefully, you will, too.
By the way, Bob will be presenting a valuable webinar: Managing Your Portfolio: The 6-Step Process to Maintaining the Portfolio You Designed, on both May 4 and May 5th. I’ll be attending, and I encourage you to join me. You can register (for free) by clicking this link.Tax-Loss Harvesting is an essential tool, and today Bob French presents an excellent overview of the concept. Click To Tweet
Tax-Loss Harvesting (Making the Most of Your Losses)
What is Tax Loss Harvesting?
How Does Tax-Loss Harvesting Work?
Things to Watch Out For
All of this seems straightforward so far. So where’d tax-loss harvesting get its reputation as an “advanced” strategy? Well, it’s not completely undeserved. There are a few pitfalls that you need to watch out for.
The primary one is the Wash Sale Rule. The wash sale rule says that you can’t buy a “substantially identical” security 30 days before, or 30 days after, the sale you are claiming a loss on. If you do, the loss will be disallowed. Essentially, this rule is there to ensure that you really are taking a loss on the transaction, and not just moving money from one pocket to the other (though you can get pretty darn close). But there are three things we should understand in the definition of the wash sale rule.
1. The timing of when you harvest your loss is crucial, and if your savings are automatically invested this can cause problems. Before you do your tax-loss harvesting, you need to double-check that you haven’t purchased the security (or one that is substantially identical, which we’ll talk about in a minute) in the previous 30 days, and you can’t buy it again for the next 30 days. In total, you won’t be able to purchase the security for 61 days. It’s important to note that this also applies to reinvested dividends, as well as things like stock compensation from your employer (including any stock that you might happen to be vesting). There is a caveat here though – if you are selling the entire position, you don’t need to worry about whether you bought any shares in the 30 days prior to the sale.
2. The “You” in this definition is pretty expansive. Not only can you not purchase the security in accounts in your name, but the security can’t be purchased in accounts that you presumably have some level of control over (like accounts in your spouses’ name). If any of these accounts buy the security in that 61 day wash sale window, it’s treated as if you did it and the losses will be disallowed.
3. I’ve used the term “substantially identical” a few times, and it’s an incredibly important tone for the wash sale rule. It’s a little bit of a term of art, but it pretty much means that you can’t buy something with exactly the same risk characteristics of the security you sold for a loss. But you can get pretty close. For instance, if you sold shares of an S&P 500 Index Fund, you couldn’t turn around and put that money into another S&P 500 fund, but you could put it into an index fund tracking another large-cap index, like the Russell 1000.
To the last point about buying substantially identical securities, when you harvest losses, you need to decide what you are going to do with the proceeds (ideally you’ll have done this before you make the trade). you can either hold that money in cash, or some other less risky asset like short-term bonds, and wait out the 30-day post-sale wash sale window, or you can put your money to work in a security that isn’t substantially identical.
The advantage of just holding the cash is that it’s simpler, which can be pretty valuable. You can just sit on the cash for a month, then reinvest the money back into the security you claimed the loss on when you are out of the wash sale window. The problem is that all of that money is sitting in cash during that period. It’s not really doing anything for you over that month.
Alternatively, you can invest the money in something that isn’t substantially identical to what you claimed the loss on. For example, moving the money from an S&P 500 Index fund to a Russell 1000 Index fund. This means that the money is staying invested – albeit in a slightly worse option than your original investment (if the new security was a better option, presumably you’d have already been invested in it as your “main” investment). If you do decide to keep your money invested, there is an important wrinkle that you need to consider – what to do at the end of the wash sale period. Any gains that you’ve accumulated in the new fund are going to be short-term capital gains, which are taxed at your ordinary-income tax rates. you’ll need to either move back to the original fund and eat the tax hit (potentially negating the tax benefits you just generated), or sit in the new investment for a year until any gains are in the long-term category. The decision will come down to how much better you think the original investment is than the placeholder.
But whatever decision you make, it’s important to recognize that tax-loss harvesting is not the main event. Your asset allocation is the real driver of your investment returns. We want to use tax-loss harvesting to augment the returns that your portfolio is generating, but we don’t want to use tax-loss harvesting to drive the portfolio. You can think of it a bit like a chainsaw. Incredibly useful in its place, but it’s definitely possible to chop off your foot if you get a little careless.
Tax-loss harvesting can be a real benefit to your portfolio, and something that can have a significant effect when the markets haven’t been kind. But it’s only part of the broader portfolio management process. If you’d like to learn more about tax-loss harvesting, and all of the other things you should be doing to keep your portfolio pointed in the right direction, register for my upcoming webinar, Managing Your Portfolio: The 6 Step Process to Maintaining the Portfolio you Designed, on either Tuesday, May 4 or Wednesday, May 5.