Is Year End Tax-Loss Harvesting Right For You?
November is the month many investors will be looking at their portfolios to see if they might take advantage of a down market by selling losing positions to reduce their income tax bills. This is called “tax loss harvesting,” and it is a way to offset short or long term gains with short or long term losses. If losses exceed gains, an investor may deduct a portion of the excess losses on their income tax returns to reduce their final tax bill.
In a typical scenario the investor plans to repurchase the security he’s targeted for sale (or a security that is “substantially identical”) at a lower cost than what he originally paid no sooner than 30 days before or after the intended sale.
Let’s look at an example: Ted booked a long term capital gain this year. He wants to avoid taxation of that LT gain by selling some securities that will realize a long term capital loss. Ted can use the LT capital losses to offset the LT capital gains. If Ted’s LT capital losses exceed his LT gain, he could use up to $3,000 of the excess losses to reduce his taxable income.
Ted has 1000 shares of ABC company stock that he bought 3 years ago for $25/share (Ted’s cost basis). The stock is now trading at $10/share. If he sells the stock he’ll realize a LT capital loss of $15/share($25 - $10), which he can then use to offset his LT gains. Ted wants to repurchase the ABC stock, but he’ll have to wait a minimum of 30 days before and after the sale to avoid violating IRS rules. Sounds pretty good so far. The question is should he?
While it seems logical to take advantage of what the tax code gives us to reduce a tax bill, tax loss harvesting doesn’t come without potential costs that Ted should consider before selling the ABC stock.
First, while Ted might not plan to repurchase the ABC stock, he still has remain out of the market for 30 days before and after the sale unless he can find a suitable investment that isn’t substantially similar to the ABC stock he sells. If the stock market moves higher during the 60 day blackout window, Ted will miss out on potential profits sitting on the sideline.
Second, tax-loss selling will have the effect of pushing taxes from the current year into the future. Let’s again look at Ted:
Ted goes ahead and sells his 1000 shares of ABC stock for $10/share. He repurchases the stock 35 days later for $9/share. Now imagine that in 24 months the price of ABC stock has risen to $50/share. Ted’s potential gain is now $41/share if he sells the stock ($50 - $9). Had Ted held on to the original shares his gain would only be $25/share ($50 - $25). By making the tax-loss sale this year, Ted exposed himself to a greater long-term gain than he would have had holding on to the stock. Ted saved himself some taxes now only to incur a higher tax bill later.
The point here is that an investor shouldn’t make an investment decision without considering the bigger picture. Every investment decision involves tradeoffs. An investor needs to understand all of the ramifications of an investment decision before making it. Work with a competent advisor or tax professional to get you in position to make the best decisions for your situation.
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[This article is intended for informational purposes only. It is not legal or tax advice, and does not create or continue an attorney-client or other fiduciary-client relationship.]