Tax-wise investors know that they should check their portfolios at the end of the year to see if there are losses that can be harvested to offset other gains. To maximize the benefit of harvesting losses, the specific lot identification method should be used. By doing so, an investor would be selling the lot with the highest percentage loss. This maximizes the current loss and the current deduction.
However, it is a mistake to wait until year-end to harvest losses. The reason is that an investment might have a loss during the year that can be harvested, but the loss might have been recouped by year-end. The opportunity to tax loss harvest would have been missed.
In addition, it is important to take any short-term loss before it becomes long term. Short-term losses first offset short-term gains that are otherwise subject to higher ordinary income tax rates. Long-term losses first offset long-term gains that are otherwise subject to lower long-term tax rates.
When realizing a loss, an investor can reinvest immediately in a similar fund or wait the required 31 days necessary to avoid the wash sale rule. Which is the prudent strategy? Since the majority of returns occur over very short periods (almost all of the returns to the market occur in less than 10 percent of the months, with the rest of the months averaging close to a zero return), the prudent strategy is to immediately buy a similar fund. Keep in mind that if there is another loss 31 days later, you can swap back and get another deduction.
There are many funds and ETFs that make good substitutes for one another, though you cannot buy two substantially identical funds (e.g., two different S&P 500 Index funds), or the loss will likely be disallowed.
There is another tax strategy of which you should be aware. If you have held a fund for more than a year, check all estimated distributions your funds plan to make, focusing on the amounts that are ordinary income and short and long-term capital gains. You can usually obtain this information from your fund prior to what is called the ex-dividend date. Check to see how much of the distributions will be ordinary income and/or short-term gains. If these are significant portions of the distribution, you might benefit from selling the fund before the ex-dividend date.
By doing so, the increase in the net asset value will be treated as long-term capital gains (taxed at the lower long-term rate). If the fund is selling for less than your basis, you should consider selling the fund prior to the distribution, thus avoiding paying taxes on the distribution (despite having an unrealized loss on the fund). You should also check to see if the distribution is greater than your unrealized gain. If that is so, and your gain is long-term, then you should also consider selling.
Tax managing a portfolio is a very important part of a winning strategy, but consult a tax advisor before implementing any strategy. By waiting until year-end to do tax planning, opportunities to tax manage might be lost.
Larry Swedroe is author of six highly regarded books on investing, including ‘The Only Guide To A Winning Investment Strategy You’ll Ever Need’ and ‘Wise Investing Made Simple.’ Comments or questions can be directed to Larry at firstname.lastname@example.org.