As 2015 draws to a close, many investors undoubtedly will be reviewing their portfolios and positioning them for the future. In addition to rebalancing or otherwise adjusting a portfolio, there is something else to consider before year's end. It's a tax strategy called tax-loss harvesting, and it could reduce investors' current tax bills.
Tax-loss harvesting is the practice of selling stocks, mutual funds, exchange-traded funds and other securities that are now worth less than what investors paid for them. By realizing or "harvesting" a loss, investors are able to offset taxes on both gains from other investments and from income.
"Harvesting losses can be an effective year-end, tax-cutting strategy, especially so with long-term capital gain tax rates for some taxpayers as high as 20% plus the 3.8% net investment income surtax," said financial advisor Jonathan Smith. "The aim of harvesting losses is to offset gains in investment securities with realized losses and use any remaining loss to offset up to $3,000 of ordinary income. Losses beyond the $3,000 limit may be carried over to succeeding years. "
This might seem like a fairly straightforward strategy; however, certain nuances make it a bit complex. Here are seven things you need to know about tax-loss harvesting.
1. The wash sale rules
When selling an investment to realize a loss for tax purposes, it is important to understand the "wash sale" rules so you don't violate them. Say that you have a loss on stock ABC that you would like to deduct this year but, longer term, you would still like to own the stock. According to the IRS, a wash sale occurs when an individual sells or trades a security at a loss and, within 30 days before or after this sale, buys a substantially identical stock or security or acquires a contract or option to do so. A wash sale also occurs if an individual sells a security, and the spouse or a company controlled by the individual buys a substantially equivalent security.
Under the rule, you can't sell the stock in your taxable account and then turn around and buy it in your IRA, or even in a spouse's IRA, during a 61-day window. This rule can get even trickier with mutual funds and ETFs. You're not permitted to sell a fund or ETF that you have a loss in and then buy another fund or ETF that tracks the same index. Consult with a financial or tax advisor for more information.
2. Reinvestment of mutual fund distributions
If you invest in mutual funds in your taxable accounts, consider having your distributions in cash instead of being reinvested. A distribution that is reinvested and used to purchase additional shares of the mutual fund could cause you to unwittingly violate the wash sale rules in the event that you are trying to realize a capital loss on the fund for tax purposes. This violation could cause the loss to be disallowed for tax purposes, wiping out the tax benefits.
3. Year-end distributions
Mutual fund investors generally receive distributions from the mutual funds they hold near the end of the year. Look at the type of distribution you are receiving. Some might be capital gains distributions, either long term or short term. These gains are also eligible to be offset by losses from the sale of investments.
Generally, mutual fund websites will start posting their estimated year-end distributions a few weeks before they are made. To the extent that information is available, you can try to determine how much of the distribution, if any, will be capital gains. Then you can plan accordingly in terms of tax-loss sales to offset some of their gains.
4. Different types of capital gains
Short-term capital gains are those realized from investments that you have owned for a year or less. They're taxed at your ordinary income rate, which can range from 10% to 39.6%, depending on your total taxable income.
Long-term capital gains are realized from investments held for over a year. Tax rates are 15% or 20% for most investors.
Losses of each type are first offset against gains of the same type, for example long-term gains against long-term losses. You will arrive at a net long-term or short-term gain or loss for the year.
There is a rather complex netting process that investors must go through. Author and investment blogger Mike Piper outlined several of the possible permutations:
- Net short-term capital gain and net long-term capital gain: The short-term loss would be taxed at investors' ordinary income rate and the long-term loss at their appropriate capital gains tax rate.
- Net short-term loss and net long-term loss after deducting each type of gain: Up to $3,000 can be used to offset other income; any left could be carried over to future years.
- Net short-term gain that is greater than the investor's net long-term capital loss: Investors will subtract the gain from the loss and the net amount is taxed as a gain at their ordinary income tax rate.
These examples are just some of the possible combinations that an investor could experience for a given year. Unless you understand the process, it is best to seek the help of knowledgeable financial or tax advisor. The nature of your gains and losses should always be considered as you go through this process.
5. Cost basis accounting
Ideally, you should be using the specific shares method of valuation for all securities held in taxable accounts. Doing so allows you to sell the specific shares of a stock, mutual fund or ETF in order to realize the largest gain or loss depending upon what you are trying to do. This method can be helpful if you purchased the fund at various times at different costs.
If you have a highly appreciated mutual fund and you have already realized some losses, for example, you might want to sell some of your lower cost shares in order to lower your cost basis in the fund and match the gains against these losses. It can work the other way as well. In short, the specific shares method allows the greatest planning flexibility.
6. Higher tax rates
Investors faced higher tax rates for 2015. The top capital gains tax rate increased to 20%, though it is 15% for many investors. The 3.8% Medicare surcharge on investment income for wealthy taxpayers brings the highest capital gains rate effectively to 23.8%. In addition, the top marginal tax rate for ordinary income is 39.6%, up from 35%.
7. Overall financial planning
Like any strategy, tax-loss harvesting is just that: a strategy. Whether and to what extent you use this tactic should be governed by your overall financial planning and investment goals. Selling holdings that fit your overall long-term investment plan to realize a short-term loss might not be the best move. That said, if you can work this strategy into your typical portfolio rebalancing, it can be an excellent way to manage your investments in a tax-efficient manner.
Tax-loss harvesting is longtime strategy employed by investors and financial advisors generally toward the end of the year. For investments held in taxable accounts, this can be a way to take advantage of positions that have experienced a loss and allow the tax savings to offset gains elsewhere.
This article originally appeared on GoBankingRates.
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