Creating a well-diversified portfolio is the foundation of growing wealth. But there’s an aspect that may help increase your overall return – and it isn’t just an investment strategy. Being strategic about handling asset value declines is also a tax strategy. It can help you offset capital gains taxes resulting from managing your portfolio or taking income in retirement.
There’s also a provision in the tax code that allows you to offset a portion of ordinary income if the loss is greater than the capital gains taxes you are liable for. And you can carry it forward indefinitely.
Being proactive and thoughtful about managing the “losers” in your portfolio should be part of your overall strategy, whether or not it makes sense to sell a position and turn a paper loss into a tax offset. Making the decision involves looking across your financial picture and investment strategy, and there are some pitfalls to avoid.
Rebalancing your portfolio to ensure that it reflects your desired investment strategy and risk tolerance is an essential part of portfolio management. Trimming back a position that has gained substantially may be necessary if it is creating more risk in your portfolio than you are comfortable with.
The sales would result in capital gains taxes, either short-term if the position was held less than a year or long-term if the asset has been in your portfolio for a year or more. Long-term capital gains taxes are much lower than the tax on short-term capital gains.
The IRS allows you to offset capital gains with a capital loss. In a situation where you don’t have gains to offset, you can use up to $3,000 of losses to offset ordinary income. That doesn’t mean you have to keep a declining position in your portfolio – you can carry the loss forward until it is all offset.
Your investment strategy is the most critical aspect, so start with investments that meet any of these criteria:
Next up are tax considerations. The IRS has created a hierarchy for how losses can be used to offset gains. First, they have to be used against the same type of gains. So, short-term losses offset short-term gains, and long-term losses offset long-term gains.
If your short-term losses are greater than your short-term gain, the excess can be applied to long-term gains and vice-versa.
Finally, if you are selling a position that you acquired over time at different costs, look at the cost basis and maximize your tax benefits by selling the highest-cost-basis shares.
You want to maintain your portfolio diversification, so unless your strategy has changed drastically, you may want to purchase a similar asset. This can get tricky. The IRS has created a rule to prevent simply switching out of a loss for the tax benefit and then repurchasing the asset at a lower cost.
It’s called the “wash-sale rule” and states that your write-off will be disallowed if you purchase the same or a substantially identical security within a 30-day window either before or after you sell to harvest a loss.
This is usually efficiently manageable – but if you have an Employee Stock Purchase Plan with a specified purchase date, or you hold company stock that has a vesting date, you’ll need to be extra careful and aware of your dates.
If the position you sell represents an industry sector exposure, you can generally replace it with a mutual fund or ETF without creating a wash sale. Just be aware of the costs of the transaction.
Tax-loss harvesting can be a useful portfolio management tool that can lower your tax costs. It can be part of an annual rebalance, or you may keep the tax benefits in mind as you opportunistically invest throughout the year. Your investment strategy should always be the priority, and to get the maximum benefit, think through the implications of the sales of both gains and losses before you execute. And of course – consulting your financial and tax advisor is always a good idea.
Collabria Capital, Inc. is a San Francisco-Bay Area fee-only fiduciary financial planner& investment manager providing wealth management services to clients locally and virtually throughout the US.
Paul Saad, Co-Founder at Collabria Capital, Inc, is a CERTIFIEDFINANCIAL PLANNER™ (CFP®) focusing on comprehensive financial planning, personalized investment management, and equity/variable compensation.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
• 3 different types of options
• How to know when to sell
• Terms to know
• How to reduce risk