by Gene Dongieux, CIO, Mercer Advisors
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As the year draws to a close, smart investors will be looking for opportunities to make their money work harder for them. This month's topic is tax loss harvesting, which is how a bear market can lower your tax bill in bull years.
The basics
When you buy investments, the price is your cost basis. Selling stock is a taxable event. If your sale price is less than your cost basis, you have a tax loss, which can offset taxes on investment gains.
Here's another example of how our emotions can defeat smart investing. Investors are about 1.5 times more likely to sell a winning stock (and pay tax) than a losing stock (for a tax loss). On the surface, that may sound like buy low/sell high, but a year later, the stock that was sold beat the stock that was held by an average of 3.5%.
The offset rule
Tax losses offset comparable investment gain taxes 1:1. "Comparable" means both are long–term (held a year or more) or both are short–term (held less than one year). If you made $500 on an investment sale and lost $500 on another investment sale, the two cancel each other out, and you owe no tax.
If you don't have $500 in gains this year, you can carry forward the loss like a pile of "get out of tax" cards until you have enough gains to cash them in. There is no limit to the amount of losses you can eventually claim. In addition, you can claim up to $3,000 a year in investment losses as credit against ordinary income.
When and why to harvest losses
Harvesting losses is not market timing. There is no judgment about where the market is or where it is going. The right time for an individual investor to harvest losses is when a mathematical algorithm says the benefits outweigh the costs. The end of the tax year is the natural time to evaluate the costs and benefits, but not the only time. Keep in mind that many mutual funds make (taxable) income distributions at the end of the year, which should be factored into the algorithm.
Even a long–term investor has gains from rebalancing. When the market is particularly active, new money may not be enough to bring your portfolio back into alignment. You incur capital gains as you sell last year's winners to redistribute capital among other asset classes.
Reinvesting right
Of course, having just sold for a loss, you now have some cash to reinvest. If you add your tax savings to the sale proceeds, you have even more to invest. For a long–term investor, the logical thing to do is repurchase at least some of the same investment at a new lower cost basis to keep your allocation intact. Unfortunately, the IRS is already ahead of you. The wash sale rule prevents you from claiming the loss when you buy the same investment within 30 days of selling it.
However, there is no penalty for buying a similar investment. Thus, investment managers who are concerned about portfolio balance often have "twin funds," meaning two funds in the same asset class (plus other requirements). Sell one, buy the other. This also allows the investor to be in the market for the most significant growth: the typically short and powerful upswing after a fall. Because, as investors who missed the 2003 rebound know, there is no tax loss on investment growth you missed while you were waiting to invest.
Does your account have tax loss harvesting?
According to a 2006 survey conducted by the Money Management Institute, there was a significant increase of tax loss harvesting from 2003 to 2006, a statistic made all the more remarkable by the fact that there were not a lot of market losses to find from 2003 to 2006. But what makes this even more noteworthy is that clients, not their money managers, initiated 77% of the increase. Clients had to ask for tax loss harvesting, so don't assume it's being done for you.
Ask your money manager if your account will have losses harvested. A pile of "get out of tax" cards is great to have when the market turns around.
References available upon request.
Gene Dongieux is the author of "If You Have It Made, Don't Risk It: A Physician's and Dentist's Guide to Investing." As chief investment officer for Mercer Advisors, he manages more than $3 billion in client assets. Dongieux has been quoted in The Wall Street Journal and Investment Advisor magazine. Contact him at [email protected].
