Get a Tax Break by Harvesting Losses

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Get a Tax Break by Harvesting Losses
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
April 22, 2005

Even in the best of times, not every investment will be a winner—some losses are inevitable. But there's a silver lining to capital losses: You may be able to use them to lower your tax bill and better position your portfolio going forward.

Take advantage of capital losses
Capital losses—securities sold for less than the original purchase price—can be used to offset capital gains on your tax return, as long as the loss sale occurs in a taxable account.

In addition, if your capital losses exceed your capital gains in any year, up to $3,000 can be used to reduce your taxable income (up to $1,500 each for married persons filing separately). Any losses still left over are available for use in future years, without expiration.

Beware the wash sale rule
Perhaps you decide to sell a stock or mutual fund to take a tax loss, but plan to buy it again because you want it in your portfolio. If so, watch out for the wash sale rule. It says if you sell a security at a loss and buy the same or "substantially identical" security within 30 days, the loss is typically disallowed for current income tax purposes.

Remember, even if you plan to realize a capital loss, it's important to stay focused on your overall goals, asset allocation, and diversification plan. The loss position in question may still make sense for all three (in other words, you would still buy it today if you didn’t already own it).

As much as you might want the tax loss, you may not want to be out of the market for an entire month just so you can avoid the wash sale rule. Likewise, you may be reluctant to increase your exposure by doubling your loss position, then waiting 31 days to sell your original shares.

Fortunately, you have an alternative. You could take the loss and immediately replace the security you sold with a similar (but not “substantially identical”) investment that suits your asset allocation and long-term investment plan.

With this strategy, you can also sell off investments that are no longer a good fit and keep your portfolio on track by reinvesting in more suitable, better-rated and/or more tax-efficient securities in the same asset class. That way, while you're harvesting losses to get the tax break, you can better position your portfolio going forward by rebalancing and improving tax-efficiency.

A hypothetical example
Let's say Joan, a single income tax filer, holds position XYZ. She originally purchased XYZ for $6,000, but it’s currently worth only $3,000. The position is part of Joan’s overall portfolio plan, which she wishes to maintain. Joan is reluctant to sell and recognize the loss, especially if it means upsetting her investment plan or being out of (or doubling) the position for 31 days to avoid the wash sale rule. What can she do?

Joan could do a little research to find a suitable replacement. For instance, using Schwab Equity Ratings®, she may find that security ZZZ is as good as or better than XYZ given her overall goals and objectives. She could simultaneously sell XYZ and purchase ZZZ, avoiding the wash sale rule while maintaining her investment plan.

Value of position XYZ before transaction: $3,000
Value of position ZZZ after transaction: $3,000 (less commissions or fees, if any)

As far as her portfolio is concerned, Joan is in the same financial position after the sale as she was before (less commissions or fees). But, if Joan has a combined federal/state marginal income tax bracket of 35%, she could also receive a current income tax benefit of up to $1,050. In effect, her loss would be reduced from 50% to 32.5%. The scenario holds true if XYZ and ZZZ were individual stocks in the same industry or mutual funds with similar investment objectives.

Harvesting losses as part of your long-term planning
Harvesting losses regularly and proactively—when you rebalance your portfolio for instance—can save you money over the long run, effectively boosting your after-tax return.

For example, imagine a $100,000 portfolio of 10 stocks returns 8% for the year as a result of six stocks gaining 20% on average ($12,000 in gains), and four stocks losing 10% on average ($4,000 in losses).

Assuming you can find better prospects elsewhere (the investment decision should always comes first), replacing the four losers makes $4,040 ($4,000 plus $40 in hypothetical trade commissions) of realized losses available to offset realized short-term gains. Alternatively, you could use the realized loss to offset a combination of short-term gains plus ordinary income up to $3,000, and carry over any unused losses for use in future years.

Assuming you could use the entire $4,040, a combined federal/state marginal tax bracket of 40% would result in a net savings of $1,576 ($1,616 tax savings, less $40 commissions paid)—not to mention a potentially better-positioned portfolio going forward.

Even in a combined marginal bracket of 30%, just taking advantage of the annual $3,000 capital loss limit against ordinary income means an extra $900 per year in your pocket (less commissions, if any). Assuming an average annual return of 8%, reinvesting $900 each year would amount to an extra $41,185 after 20 years.

The bottom line
As an investor, you should focus primarily on your overall asset allocation, your investment performance, and keeping costs as low as possible. The smart use of capital losses can play a role in each of these areas.

As always, when dealing with your personal tax situation, consult an experienced tax professional to determine what's best for you.

The information provided is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, or legal, tax, or investment advice, or a legal opinion.

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