Make some lemonade from the lemons that the market has given to your portfolio by “harvesting” some losses. This will reduce your tax bill next year.
When to Harvest Losses
Although it’s generally not a good idea to sell a security strictly for tax reasons, the tax implications of trading can and should be included in your consideration of whether and when to sell. If you invest in individual securities, you will not be able to buy them back within 30 days (see “wash sale rule” below), but you might be able to invest in something roughly similar (such as another stock in the same industry). However, if you invest using index funds, such as ETFs, it is fairly easy to maintain essentially the same economic exposure while taking advantage of loss harvesting opportunities by switching to another fund that uses a slightly different underlying index.
Because of the trading expenses and record keeping hassles involved, you will only want to do tax-loss harvesting when the benefits are large enough to make it worth the effort. And of course, tax-loss harvesting is something you will only want to do in a taxable account--it's not for your IRA or 401(k). A very large drop in the market like we have recently experienced makes it more likely that you may have sizable losses on positions that were purchased within the past year—the ones that would qualify as short-term. These are the most valuable from a tax standpoint.
In short, now is probably a good time to consider making lemonade with your portfolio lemons.
Capital Gains—The Long and the Short of It
When you sell a security for more than what you paid for it (its “tax basis”), you will owe tax on that gain. Gains on securities held for one year or less are considered “short-term” and are taxed at ordinary income tax rates of up to 37%, the same as earned income. However, gains on securities held longer than a year are taxed at preferential “long-term” capital gains rates. For most people, the rate will be 0% or 15%, although for very high earners it can be 20%.
When you file your taxes, you must “net” your gains and losses against each other. First, short-term gains and losses are netted against each other. Then long-term gains and losses are netted. Finally, the results of those two calculations are netted. If the net is a loss, you will be able to reduce your ordinary income by up to $3000 (applying net short-term losses first). Any unused net loss, short- or long-term, can be carried over into future years.
Because short-term gains are taxes at higher, ordinary income tax rates, the realization of short-term losses is particularly attractive because they can offset short-term gains that would otherwise be taxed at high rates. (The realization of long-term losses will reduce your long-term gains first, but those rates are lower, so offsetting them is not as valuable.) Consequently, if you have investments at a loss that are about to become long-term losses, it may be worthwhile to harvest the losses while they are still short-term losses.
The Wash Sale Rule
IRS rules prohibit “wash sales,” which is the sale and repurchase of a “substantially identical” security within 30 days. It is clear how to apply this rule to individual securities, but its application to funds is a bit murky. For example, are two different ETFs based on the S&P 500 “substantially identical?” Opinion seems to be mixed. At a minimum, reinvesting in an ETF with a slightly different underlying index would provide safer ground.
What happens if you accidentally buy back the same security within 30 days of selling it? You still get to take the loss on your taxes eventually, but not until you sell the security without triggering the wash sale rule. Your wash sale simply adjusts the tax basis you have in the security.
The Bottom Line
Take the market downturn as an opportunity to sell some securities that you have owned less than a year for a short-term loss, particularly if you are inclined to sell them for investment reasons.