It’s that time of the year to take a good look at your investment portfolio and evaluate what went right and what went wrong during the past twelve months. If you’re like most investors, you will have both winners and losers. The good news is that, through tax-loss harvesting, you can turn losing positions into a lower your tax bill.
The Merriam-Webster definition of the verb harvest is “to gather”. And just as you would gather crops in a field, you can also gather—or harvest—losses in your investment portfolio. And ‘tis the season. The performance results are in, and you still have time to execute trades in order to recognize your gains or losses in the 2016 tax year. Since December 31 falls on a Saturday this year, your deadline to execute trades is December 30 at 1:00pm when the market closes for the year.
Throughout the year, you should always be conscious of the tax consequences of any trades you make. When possible, you should offset gains with losses in stock, bond or ETF positions. For example, at Castle Wealth Management, we typically avoid generating short-term gains and put assets that generate mostly ordinary income—like high-yield bond funds or investment-grade bonds—into qualified accounts when possible.
Nonetheless, a full year-end review is a must. In your taxable accounts, look for trades that have generated gains, and then look for positions with losses to offset those gains. At Castle, we consider harvesting opportunities when stock, ETF or mutual fund positions have at least a $500 loss. We also review clients’ prior tax returns and coming-year estimates, if available, and modify the tax-loss harvesting strategy as needed. For example, if a client has tax-loss carryforwards, we will not necessarily engage in tax-loss harvesting, because the tax-loss carryforwards can be used to offset the gains.
When you’re figuring out how you want to harvest your losses, consider the following: Do you own holdings in industries that are no longer desirable? Do any of them no longer fit your strategy? Have their prospects for the future diminished? If you answer yes to any of these questions, consider harvesting these losses first. Losses can be either short or long term. If you’ve realized short-term gains in your portfolio this year, consider selling short-term positions at a loss if you can. Short-term gains are taxed at a higher marginal rate than long-term gains so it is best to offset them with short-term losses when possible.
You also need to be aware of the “wash sale rule.” The “wash sale rule” states that if you sell a security at a loss and buy the same or “substantially identical” security within 30 days before or after the sale, the loss is typically disallowed for current income tax purposes. In other words, you can’t take it as a deduction on your tax return. To avoid triggering the “wash sale rule,” we suggest you replace the security with a similar ETF or mutual fund to maintain your portfolio target allocation.
However, even if you don’t have capital gains in your investment portfolio, tax-loss harvesting can be a tool to lower your ordinary income tax bill. In addition to lowering your tax bill, the real benefit is taking that tax savings and re-investing it for future growth.
Ursula Auger, CFA, CFP® is the Portfolio Manager at Castle Wealth Management and President of CFA Society South Florida.