After years of below average market fluctuation, volatility has spiked during the 3rd quarter of 2018. From trade war concerns to Federal reserve rate hikes, the market has been digesting increased economic uncertainty. While volatility has not necessarily been isolated to stocks or bonds, some investments have been impacted by this volatile downdraft more than others. In fact, certain asset classes such as bonds, emerging markets, developed international markets, small-cap and mid-cap value stocks (to name a few) could all be down year-to-date. While no one enjoys seeing losses in their portfolio, there are some techniques to consider. Tax-loss harvesting may be one approach to reducing some of the pain of the market’s sucker punch – at least a little bit.
How it works
So what is tax-loss harvesting and why might you consider it? Tax-loss harvesting is the process of selling investments held in taxable accounts that are valued at less than their cost basis in order to realize a loss. (The cost basis is the amount you paid for tax purposes adjusted for reinvested dividends, stock splits, etc.) This loss can be used to offset other investment gains or $3,000 per year of losses can be used to offset ordinary income if no gains exist. (Excess losses can be carried forward and/or gradually written off against income/gains each year.) Remember tax-loss harvesting does not apply to retirement accounts and does not prevent investment losses.
The real benefit from tax-loss harvesting comes from the difference between short and long-term capital gains rates. Depending on your income level, the difference between long-term capital gains and short-term capital gains can be as high as 17%. Realizing losses in a taxable account to offset short-term capital gains or income, both of which are taxed at higher ordinary income rates, can be an effective tool to reduce income tax for some investors.
There a few important points to consider before jumping out of any investments. First, do not allow managing taxes to override the development of a solid investment portfolio. While taxes are an important consideration, be careful not to allow them to be the driving force behind the investments you choose. Next, watch-out for triggering the wash-sale rule. Purchasing a substantially identical investment 30 days before or after the sale may result in the IRS preventing you from claiming a loss. Instead, some tax experts suggest a strategy of purchasing an investment that is not “substantially identical” but still highly correlated to your initial holding. (Two investments are considered to be highly correlated if they are expected to perform similarly.)
This may be a way to realize the tax-loss without having your sale proceeds parked in cash for a month – this may allow your funds to remain invested toward your long-term goals. Keep in mind that the risk here is that your similar but not “substantially identical” investment could underperform your original holding, negating the benefit of the tax-loss altogether.
Tax-loss harvesting may be appropriate for investors that have either identified assets they are selling for a loss that are no longer congruent with their investment plan or have realized other capital gains (especially short-term gains) that need to be offset by a loss. Selling depreciated assets that may no longer be appropriate for your long-term goals can be a great way to rebalance your portfolio while at the same time realizing a loss that can result in potential tax savings.
Harvesting tax-gains at 0%
Depending on your individual goals and circumstances, it may actually be even more beneficial to harvest gains. You may be wondering how selling an investment to take a capital gain can be helpful. For 2018, if you earned $77,200 or less and you are married filing jointly, or $38,600 if you are a single filer, you may be eligible for a 0% long-term capital gain rate. Remember, this powerful strategy only applies to investments held for greater than one year within a taxable account.
This may be especially useful if you find that your income has suddenly declined in a given year as this could allow for the sale of appreciated assets at very attractive capital gains rates. While there are no wash-sale rules that prevent selling investments for a gain and buying them back immediately, realizing gains can impact the taxation of social security and various deductions and tax credits, as well as state income taxes. As a result, be sure to coordinate the realization of capital gains with other financial strategies you may be considering including any Roth conversions. Bottom line – harvesting gains up to the maximum 0 percent threshold can provide tax savings for some taxpayers.
Tax planning that is coordinated with investment management may help investors to control tax liability today and in the future. Consider reviewing IRS publication 550 – Investment Income and Expenses for more information on capital gains and losses. This is not meant to be a substitute for individualized tax advice so consider speaking to your tax adviser to determine the most appropriate approach for you.
Kurt J. Rossi, MBA, CFP®, CRPC®, AIF® is a CERTIFIED FINANCIAL PLANNERtm Practitioner & Wealth Advisor. He can be reached for questions at 732-280-7550, kurt.rossi@Independentwm.com, www.bringyourfinancestolife.com & www.Independentwm.com. LPL Financial Member FINRA/SIPC.