Pros And Cons Of Annual Tax-Loss Harvesting

Roger Wohlner for Investopedia writes: With the end of the year upon us investors are looking for ways to reduce their tax bills. One tactic that is often used is tax-loss harvesting. Tax-loss harvesting is the strategy of selling stocks, mutual funds, exchange-traded funds (ETFs), and other investments that are worth less than you paid for them in order to use those losses to offset realized gains on other investments.

Is this strategy a good idea for you? It depends.

MORE THAN JUST TAX CONSIDERATIONS

It's generally a poor decision to sell an investment, even one with a loss, solely for tax reasons. , tax-loss harvesting can be a useful part of your overall financial planning and investing strategy as long as it doesn’t lead to decisions that are ultimately in conflict with that strategy. (For more, see: When to Dump Portfolio Losers.)

INCREASED TAX RATES

Three key tax rates have increased this year:

• The top rate for long-term capital gains has increased to 20% from 15%.
• The new 3.8% Medicare surtax for high-income investors has made the highest effective capital gains tax rate rise to 23.8% for these taxpayers.
• The highest marginal rate for ordinary income has increased to 39.6% from 35%.

This potentially makes investment losses more valuable to higher income investors.

UNDERSTAND THE 'WASH SALE' RULE

The 'wash sale' rule says that if you sell an investment holding in order to recognize and deduct that loss for tax purposes you cannot then buy back that same asset or another investment asset that is “substantially identical” for 30 days following the sale. (For more, see: Tax-Loss Harvesting: Reduce Investment Losses.)

In the case of an individual stock this is pretty clear: If you had a loss in Exxon Mobil Corp. (XOM) and wanted to realize that loss you would have to wait 30 days before buying back into the stock if you wanted to own it again. This can actually be as much as 61 days because you need to wait at least 30 days from the initial purchase date to sell and realize the loss and then you need to wait at least 31 days before repurchasing that identical asset.

In the case of a mutual fund, if you realized a loss in the Vanguard 500 Index Fund (VFINX), you couldn’t buy the SPDR S&P 500 ETF (SPY), which invests in the identical index. You likely could buy the Vanguard Total Stock Market Index (VTSMX), though, as this fund tracks a different index.

Many investors use index funds and ETFs, as well as sector funds, to replace stocks sold in order to not violate the wash sale rule. This might work out for you but can backfire for any number of reasons, including extreme short-term gains in the substitute security purchased or if the stock or fund sold goes way up in price before you have a chance to buy it back. You should also be aware that the wash rule cannot be avoided by buying back the asset sold in another account, such as an IRA. (For more, see: Taking the Sting out of Investment Losses.)

PORTFOLIO REBALANCING

One of the best scenarios for tax-loss harvesting is if it can be done in the context of the normal rebalancing of your portfolio. As you look at which holdings to buy and sell torebalance, pay attention to cost basis.  This approach won’t cause you to sell solely to realize a tax loss that may or may not fit your investment strategy. (For more, see: Rebalance Your Portfolio to Stay on Track.)

A BIGGER TAX BILL DOWN THE ROAD?

Some financial advisers contend that consistent tax-loss harvesting with the intent to repurchase the sold asset after the waiting period dictated by the wash sale rule will ultimately drive your overall cost basis lower and result in a larger capital gain to be paid at some point in the future.

This could well be true on two counts: If the investment grows over time your gain can get larger. Also, we don’t know what will happen to the capital gains tax rates in the future. 

The flip side of this, however, is that the current tax savings might be worth enough to offset higher capital gains taxes down the road based on the concept of present value, which would say that a dollar of tax savings today is worth more than any additional tax to be paid later on. Clearly this will depend on a variety of factors. (For more, see: Does Tax Loss Harvesting Really Work?)

NOT ALL CAPITAL GAINS ARE CREATED EQUAL

Short-term capital gains are those realized from investments that you have owned for a year or less. They're taxed at your marginal tax rate for ordinary income. The top marginal tax rate on ordinary income was 39.6% in 2014. (For related reading, see: Capital Gains 101.)

Long-term capital gains are realized from investments held for over a year and are taxed at significantly lower rates. For many investors the rate on these gains is 15%, the highest rate being 20%. Remember that for the highest incomes, the additional 3.8% Medicare surtax comes into play here as well. (For related reading, see: Capital Losses and Tax.)

Losses of a given type are first supposed to be offset against first against gains of the same type for example long-term gains against long-term losses. If there aren’t enough long-term gains to offset all of the long-term losses then the rest of the long-term losses could be used to offset short-term gains and vice versa. If there are still losses left then up to $3,000 in investment losses can be deducted against other income in a given tax year with the rest being carried over to subsequent years.

Certainly one of the considerations in the tax-loss harvesting decision in a given year is the nature of your gains and losses. You'll want to analyze this prior to moving forward. 

MUTUAL FUND DISTRIBUTIONS

With the stock market gains of the past few years many mutual funds have been throwing off sizable distributions, some of which are in the form of both long and short-term capital gains. These distributions also should factor into the equation.

LOOK AT THE BIG PICTURE

Tax-loss harvesting is but one tactic that can be used on the path toward achieving your financial goals. In order to determine if this is a good idea for you step back and first look at your overall tax situation.

THE BOTTOM LINE

While it is a good idea to review your portfolio for tax-loss harvesting opportunities at least annually, whether or not to move forward should be evaluated in the overall context of your tax situation and whether or not these transactions fit with your overall investing strategy. Tax reduction is a strategy and not an end unto itself. Make sure to consult with a financial advisor or tax professional knowledgeable in this area. (For more, see: 7 Year-End Tax Planning Strategies.)