Author: Brent Lemieux CFA® CPA
We all know that investing in the market is not for the faint of heart. The market often behaves like a manic depressive, changing its mood from one day to the next. This can be scary when things get ugly and the market tanks. It’s usually best to stay the course in these situations, as uncomfortable as that can be.
What if there was a way to gain from a temporary decline – to turn a bad situation into a good one? Enter tax loss harvesting.
Tax loss harvesting explained…
The basic idea of tax loss harvesting is to take advantage of a temporary decline in your investments by saving on your tax bill. When one of your investments declines below its basis, a.k.a. what you paid for it, it is trading at an unrealized loss. If you sell it, you realize this loss and you can use it to offset current ordinary income (up to $3,000 per year for an individual) and any capital gains you’ve incurred by selling investments at a profit (no limit). If you don’t “use” the loss this year it carries forward indefinitely allowing you to use it in the future.
This strategy allows you to save money on your current tax bill while you wait for the market to recover.
A few considerations…
- It is best to reinvest your tax savings in your portfolio. Tax loss harvesting saves you money on your tax bill today by deferring the tax you owe to a later date. If you invest the money today it has the opportunity to accumulate and be worth more than what you will owe in the future. If you spend it today, you are simply moving the timeline up on when that money is enjoyed.
- You may have heard that it is a bad idea to sell investment when they are down, and we generally agree. However, with the multitude of ETFs and Mutual Funds available today, you can easily find a comparable fund. For example: Let’s say funds ABC and XYZ both hold large US Company stocks. If you own ABC and it decreases in value, you can sell it to harvest the losses and invest the proceeds in XYZ. It is important to make sure that these funds are comparable to each other (i.e. their expected return and risk are very similar).
- Avoid wash sales. A wash sale occurs if you buy the same fund that you sold at a loss 30 days before or after the tax loss harvesting. It also occurs if you use a substitute fund that tracks the same index. Luckily, you can still find similar funds that track similar but different indexes. These rules can be tricky. Be careful about related party purchases of the same security or buying the same security in your IRA or 401(k)-we suggest talking to a tax advisor.
- Make sure you only pursue this strategy in your taxable accounts. The benefits of tax loss harvesting do not apply to your IRA or 401(k) accounts.
Does all of this sound complicated? Windward routinely monitors our client’s accounts for tax loss harvesting opportunities, as well as providing comprehensive wealth management services. If you are interested in meeting with a Windward advisor, contact us today.
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