This is the time of year when our thoughts are focused on family, holiday gatherings, gift lists… and tax planning! With investment activities subject to tax rates ranging from 0% to 37%, reducing or delaying tax obligations can significantly add to long-term returns. Tax management, including year-round tax loss harvesting, minimizing exposure to capital gains distributions and selecting investments with favorable tax attributes are all important elements of the portfolio management process.
It can be frustrating to see the stock market and investment portfolios go down. But is there a way to benefit from losses incurred from investing? Even in a good year, some investments in a diversified portfolio may lose money, creating opportunities for tax management. While no investor wants to incur a loss, benefits can be reaped through a strategy called tax loss harvesting. This process enables an investor to sell securities that have lost money and use those losses to reduce their overall tax liability. Any investment loss can be used to offset all taxable capital gains and up to $3,000 of ordinary income per year . Losses can also be carried forward for use in future years.
Though many managers leave this process for year-end, we have found it to be more advantageous for portfolios to strategically harvest throughout the year. If a loss is likely to be permanent, a tax savings can be generated by replacing an underperforming security with a new investment. If a loss is due to temporary market fluctuations, consider a temporary sell out of a position to generate tax savings before strategically re-entering the position after a 30-day regulatory lock-out period.
A related year-end activity is the distribution of capital gains by certain investment vehicles. Unfortunately, investors are responsible for most capital gains created by these securities, regardless of when the initial purchase occurred. When this does occur, determine if it is better to hold the position and pay taxes on the capital gain distribution or sell the position before the distribution and pay taxes on any personal gains incurred. Importantly, we also recommend assessing any embedded capital gains and likely tax consequences of each investment before purchasing to mitigate exposure to future capital gains. Low turnover, for example, helps limit distributable taxable gains, making us partial to investment choices that limit trading activity.
Finally, some securities offer structural tax advantages. ETFs are subject to more favorable tax treatment than other comparable investments. When making transactions, ETFs are able to exchange securities and delay capital gains recognition. In contrast, other investments must buy and sell securities, which creates immediate tax consequences. This inherent difference can sometimes be a significant advantage in taxable accounts.
1 Charles Schwab: Reap the Benefits of Tax – Loss Harvesting to Lower Your Tax Bill; Adams, Hayden. Oct. 31, 2019