Different investments tend to appreciate in value at different rates over time. This can cause the ratios in investment portfolios (such as the ratio of stocks to bonds) to shift away from their targeted levels. However, many investors are reluctant to rebalance their portfolios when these target ratios shift because they do not want to incur capital gains taxes. One strategy to control the timing of these taxes (they will seldom be eliminated) is to offset a capital gain realized on the sale of one investment with a capital loss realized on the sale of another investment (a gain or loss is realized when an actual sale takes place).
Capital losses, both long term and short term, can be used to offset capital gains, thus lowering, or in some cases eliminating, the taxes due on a realized gain. If an investor has a greater loss than gain, the excess loss can be used to reduce up to $3,000 of ordinary income. Any loss not used during the current tax year can be carried forward indefinitely to future tax years.
Harvesting tax losses can be difficult using individual securities because of what is called the “wash sale” rule. This rule states that, in order to use a capital loss to offset a capital gain, the security that is sold at a loss cannot be repurchased within 30 days of its sale. This means that, in order to capture the tax loss, a stock investor might have to either buy a different stock or be out of the market for 30 days.
Harvesting tax losses can be more effective in a mutual fund portfolio. With the plethora of mutual funds available to investors, it is relatively easy to find one fund with fairly identical characteristics to another. If an investor wishes to realize a loss in a particular mutual fund, he can sell that fund, realize the loss, and immediately buy a new fund with identical characteristics, thereby avoiding being “out of the market” for thirty days.
A second use of tax-loss harvesting also pertains to an investor holding a mutual fund portfolio. Mutual funds earn dividends on the securities that they hold. They also buy and sell securities during the year, incurring capital gains and/or losses. They are required to pay out these dividends and gains to their shareholders each year. An investor who has had no transactions in his portfolio during the course of a year could still receive a capital gains distribution on which he has to pay taxes. Having to pay capital gains taxes on a fund that has actually suffered a loss during the year can be disheartening. An investor can avoid this situation by selling the fund before the capital gain distribution and using the proceeds to buy a similar fund that has already made its distribution. This gives the investor some control over his taxes payable.
While the harvesting of tax losses is a useful vehicle to mitigate the sting of having to pay capital gains taxes in the current year, an investor needs to realize that this strategy does have its limitations. In some cases, the transaction costs of selling an investment at a loss (particularly when dealing with individual stocks) can outweigh the advantages. In addition, an investor should not look for situations to minimize his current tax liability if by so doing he would jeopardize the integrity of his investment program.
For additional information on this or related topics, or to learn more about the investment management and financial planning services offered by Bingham, Osborn & Scarborough, LLC, please visit our website at www.bosinvest.com.
Updated September 2015
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