A gift you can accept any time of year
Robert J. Pyle, CFP®, CFA, AEP®
Now is the time of year that thoughts turn to Holiday spirit, snow covered landscapes and cozy fireplaces. It’s also a great time to consider some tax-loss harvesting—maybe not what you expected in your Holiday stocking, but often a more valuable gift, courtesy of Uncle Sam. Even better, loss harvesting is a gift that you can give yourself all year round. Just make sure to ask your advisor for assistance. This is not an area in which you want to be a do-it-yourselfer.
The term “loss harvesting” can have unpleasant connotations, but a well-diversified portfolio will periodically have positions at a loss. Harvesting those losing positions helps mitigate their impact on your overall portfolio by providing a tangible tax benefit. Losses from positions sold below their cost basis can be used to offset gains from elsewhere in your portfolio—plus an additional $3,000 of remaining losses each year can be carried over to reduce your taxable income. Losses can be carried forward into future years. So, having a large chunk of losses stored up can allow for tax-free realization of subsequent gains such as when you rebalance your portfolio, sell a highly appreciated position, or want to make a gift to a child, grandchild or favorite cause.
Despite all the recent gyrations in the market, the year 2018 has been pretty flat overall for U.S. stocks. So, no tax loss harvesting opportunities this year, right? Not so fast. Chances are you have some international holdings in your portfolio that you purchased in the last year. Based on what’s happened to global markets recently, those holdings are probably down for the year. That’s going to be your first place to look for losses.
Why it’s so hard to let go
Behavioral finance studies show that people feel the pain of a loss much more than they enjoy the thrill of a gain. Investors will keep holding on to a losing position hoping the stock will eventually get back to the price at which they purchased it. Behavioral finance experts call that “anchoring.” If it’s the stock of a company they used to work for, investors will wait months, even years, to get back to breakeven (i.e. “gamblers fallacy”), because they think they know the company better than outside investors and “it’s only a matter of time” before the stock rebounds.
Don’t let your emotions and personal biases get in the way of sound decision-making. That’s why we recommend that most clients hold diversified mutual funds rather than individual stocks. You’ll get much less emotionally attached to funds than to equities, which makes it easier psychologically to sell losing positions--individual stocks are just too volatile.
Tax lot accounting
If you periodically invest in a fund, say after a biweekly paycheck, then you will have many, many positions at various cost bases. Following a market correction, your overall holding may still be showing a gain, but some of the positions are at a loss. It all depends on when you bought them. Designating the highest-cost basis lots for sales can increase the amount of loss harvesting you and your advisor can do. We have a powerful computer program that helps us scan all the different lots of the investments you purchased over the years. Then we use the HIFO cost basis (highest in first out), to sell the ones lots with the highest cost basis in order to minimize your taxes.
Just make sure you and your advisor are adhering to the “wash rule,” which disallows the recognition of a loss if the same, or substantially similar, security is purchased within 30 days of the sale (before or after). Through our partners at Dimensional Fund Advisors, we can offer you both tax-managed and non-tax managed funds that are similar, but which serve different purposes for tax planning.
For example, if you’re taking a loss on the tax managed fund, we can buy the non-tax managed fund and your overall asset allocation won’t change at all. Again, your overall allocation will be nearly identical, but the funds are essentially different and so the wash rule doesn’t come into play.
Your greater goals
When harvesting a loss, make sure you remain true to your existing investment plan. To prevent a tax-loss harvest from knocking your carefully structured portfolio out of balance, we reinvest the proceeds of any tax-loss harvest sale into a similar position (but not one that is “substantially identical,” as defined by the IRS). We also do this on the same day so your proceeds are not sitting in cash and you are out of the market for a day. Typically, we return the proceeds to your original position no sooner than 31 days later (after the IRS’s “wash sale rule” period has passed).
Loss harvesting is especially valuable when markets are highly volatile and peppered with steep drops. More often than not, we can find a position you can sell at a loss. With the left over proceeds, we can help you find a buying opportunity elsewhere that meets your investment plan and retirement goals—just not in the same fund.
Now that’s a gift that keeps on giving!
Robert J. Pyle, CFP®, CFA, AEP® is president of Diversified Asset Management, Inc. Contact Robert at 303-440-2906 | email@example.com.
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail firstname.lastname@example.org.
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