Although April 15 might seem a long way off, it's never too early to start thinking about your taxes and how to get the most money back.
In some sense, now is a great time to start thinking about your taxes, as we're less than seven weeks from the end of the year. With the exception of a few tax-advantaged retirement accounts -- such as a traditional IRA, which allows you to contribute for your current-year taxes all the way up until April 15 of the following year -- all of your tax moves need to be completed before Jan. 1, 2015 in order to be counted on your 2014 tax return.
The smart tax move you should consider
One potentially smart tax move investors may want to consider, given another fairly strong year for the stock market, is tax-loss selling, also known as tax-loss harvesting.
Not every investment you make is going to be a winner -- and that's OK. The goal of investing for the long term is to let your winners run wild for years or decades and to get rid of companies that no longer fit your investing thesis. Stock losses happen to the best of us -- even to the Oracle of Omaha, Warren Buffett!
The good news is that you might be able to use any losses to your benefit come tax time. The IRS allows you to sell stocks at a loss and to use that loss to offset some or all of your capital gains during the year. In addition, if your stock loss proves to be higher than your capital gains for the year, you can use your tax-loss to count against other income, such as wages or stock and mutual fund dividends, for example.
Of course, you should be aware that there are limits to the IRS' generosity with regard to how much of your income you can offset with investment losses. According to the tax code, you can claim a maximum of $3,000 in investment losses per year against your non-stock income. Thankfully, if you have any "leftover" losses following the offset of any capital gains and the $3,000 against your non-stock income, you can carry these losses forward indefinitely and use them against future capital gains or non-stock income.
Why you should make this move sooner than later
There's no shame in tax-loss selling, and if you're considering making this move, it's best to do it sooner than later.
The reason is that investors, like clockwork, often decide to sell their stock at a loss in December to take advantage of tax-loss harvesting benefits. An abstract published in the Journal of Finance in 2006 showed that tax-loss selling was the primary reason for the "January effect" at the beginning of the following year, which is when stock prices typically pop. The problem with selling late in the year is that it tends to put pressure on already weak stocks, potentially causing your losses to widen. By selling in November, you might beat the rush to the exit and give yourself an opportunity to lock in a better price.
Furthermore, selling before December could give you an opportunity to take advantage of the late rush to sell stock. Instead of being caught in a tax-loss selling spiral, you might be able to buy back into a stock you sold -- this time at a much better price. As Warren Buffett famously said, "Be fearful when others are greedy and greedy when others are fearful."
One thing to be aware of, though, is the wash sale rule. According to the IRS, a wash sale is defined as buying or trading in a "substantially identical stock" within 30 days before or after a tax-loss sale. In other words, if you sell a stock at a loss and then repurchase it back within the next 30 days, you can't claim that loss against your capital gains or income. This means if you plan to sell stock for tax purposes, you'll really want to make sure you have no intentions of repurchasing the stock within the next 30 days.
Before you sell, consider this
While there are clear tax advantages to tax-loss selling, you'll want to give careful consideration to parting ways with your stock(s) before making the move to sell.
Don't forget that the biggest gains are made by holding on to your stocks over the long term and allowing your gains and dividends to compound over time. For example, if a company pays a steady dividend, has an intact business model, and looks poised to stand the test of time, it may not be wise to sell it, even if it has struggled a bit this year. The past two recessions point out precisely why it's beneficial to hold game-changing companies over the long term, as many stocks are now much higher than where they were prior to the recession.
The key point here is to not be hasty with your decision to sell. Make sure a tax-loss selling candidate truly no longer fits your investment thesis before you part ways with it. And if you do decide to sell, make sure you don't rebuy that same stock for a minimum of 30 days.