From Wall Street’s Best Editor Nancy Zambell: I’m often asked about the pros and cons of taking investment losses against income at the end of the year. This article by N. Denise Falkner of Stack Financial Management thoroughly examines the issue, for a long-term view.
For some investors, tax loss selling has become a year-end ritual that is rarely questioned. It has essentially become a tradition, as automatic as eating turkey on Thanksgiving. The potential benefits of realizing current losses to offset gains are widely publicized; however, there are also several potential pitfalls to be aware of as well. While Thanksgiving turkey may indeed be for everyone, whether or not one should harvest losses requires much greater consideration.
What is Tax Loss Selling?
The idea behind tax loss selling is very enticing. Sell investments showing a loss to offset capital gains (as well as up to $3,000 in income per year), thereby reducing your overall tax bill next April. These tax savings theoretically provide benefit for the “time use of money” (i.e., a dollar is worth more today than tomorrow).
For instance, suppose you have realized $10,000 in long-term capital gains for the year. You also hold a stock that is currently showing a $2,000 loss. This position can be sold and the realized loss will offset against the capital gains netting $8,000 in long-term capital gains. Depending on your tax rate, realizing this loss could save between $300 and $500 on your current tax bill.
If a loss is realized, however, the IRS “wash sale” rule will disallow that loss if the same investment, or a “substantially similar” one, is purchased within the 30 days prior to or after the sale. Once the 30 days have elapsed, the investment can be purchased again. Given that the stock was exited at a loss, the new tax basis upon repurchase will probably be lower than the original cost basis.
So, although you have saved on the current tax bill, you’ve likely lowered the basis which could result in higher gains down the road. This is why, in most cases, harvesting losses represents only a deferral of capital gains tax, and not an avoidance of them.
When Tax Loss Selling is Most Beneficial
Tax loss harvesting can be most beneficial when managing a taxpayer’s overall adjusted gross income (AGI) level. Managing AGI can be very important, especially for retirees whose Medicare premiums and taxability of Social Security benefits are determined in large part by these levels. Higher wage earners can also benefit by managing taxable income levels. Today, there are effectively four different capital gains rates. If an investor is near the threshold that is subject to the 3.8% Net Investment Income surcharge or triggers the higher 20% capital gains tax rate, then tax loss harvesting could prove beneficial.
Tax loss harvesting may also be advisable if you are in a higher than normal tax bracket this year. This could be the case if you received a large one-time bonus or if you sold a business or other highly appreciated capital asset. If the bonus or gains from the sale cause you to be in an elevated tax bracket and subject to higher than normal taxes, tax loss selling can be particularly valuable provided there are sufficient unrealized losses in the portfolio to reduce your tax bracket. In general, if you expect to have a lower tax rate in the future, deferral of taxes is a good idea.
The most advantageous use of tax loss selling is in offsetting short-term gains or regular income (subject to limits), both of which are usually taxed at much higher rates than long-term capital gains. Otherwise, harvesting losses simply to reduce long-term capital gains doesn’t offer nearly as much in tax savings and the potential disadvantages could easily outweigh the benefits.
The Potential Pitfalls
Notwithstanding the benefits discussed above, there are also many potential pitfalls associated with tax loss selling. The most notable reasons to rethink tax loss harvesting include the following:
1. No one knows what capital gains tax rates will be in the future. If capital gains tax rates increase in future years, or if additional surcharges are imposed (like the 2013 Net Investment Income Tax), any taxes which are deferred will then be subject to the higher rate.
2. Transaction costs can reduce the benefit. In our experience, unless the decline from original purchase exceeds 20%, it doesn’t usually make financial sense to capture the loss. This is because any tax savings can easily be cancelled out by the combination of transaction costs and even a small increase in the price of the security during the wash sale period.
3. Administrative hassle can lessen the appeal. If multiple tax lots are owned, it’s possible that some lots have a gain and others a loss. If the default accounting method (generally first-in, first-out) does not capture the desired loss, the tax lot will have to be specified at the time of trading.
4. Tax loss selling may impact portfolio diversification. It’s not unusual for an entire sector to be under pressure in which case all stocks showing a loss could be in the same area of the market. If you realize losses in all those holdings, you may be exiting an entire sector of the market, hereby reducing portfolio diversification and increasing risk.
5. The stock price may appreciate during the wash sale period causing the investor to lose more in potential gain than saved in taxes.
This last item is by far the largest potential downside of tax loss selling. While the risk can be somewhat mitigated by purchasing a “proxy” for the stock during the wash sale period, if this “proxy” increases in value during the 30 days it is owned, a short-term gain has now been realized. When the idea is to reduce taxes, short-term gains should obviously be minimized.
The potential for the stock price to move significantly is exacerbated by the popularity of tax loss selling at year-end. The stocks posting the largest declines during the year are the prime candidates for harvesting tax losses.
This selling pressure can cause the price to decline even further in the final months of the year which could set the stock up for a large bounce in January.
An Example of Tax Loss Selling Gone Awry…
To illustrate this, we took a look back at 2011 which, like this year, had relatively flat market performance, but a significant midyear sell-off. The table below examines all of the S&P 500 stocks which declined in excess of 25% in the first ten months (January through October) of that year. Over this time frame the S&P 500 had gained 1.3%, so the 54 stocks listed here performed much worse than the market and represented optimal targets for tax loss harvesting.
At least in part due to increased selling pressure from tax loss selling, these stocks generally declined even further in the final two months of the year, falling on average another 5%. In fact, 39 of the stocks on the list (72%) showed losses in November and December even though the S&P 500 posted a small 0.7% gain. Then, after the pressure of tax loss selling subsided, almost two-thirds of the stocks on this list exceeded the S&P 500 gain of 4.5% in the first month of the new year. On average, these poorest performing stocks in the first ten months of 2011 went on to more than double the S&P 500 return in January 2012.
…and the Lessons Learned
If you had sold these assets to realize the loss, the wash sale period may have caused you to miss the significant appreciation in January. The potential gain given up by missing this bounce in oversold stocks could easily void any tax savings. In an ongoing bull market, one would expect the stock market to continue to increase in value and the risk of missing a gain during the wash sale period is heightened. Conversely, this risk might be reduced if we are in a confirmed bear market. Therefore, tax loss selling may be more appropriate if the market is in the midst of an overall long-term bear market.
How and When to Use Tax Loss Selling to Your Best Advantage
There is no universal guidance regarding when it’s best to utilize tax loss selling. It will almost certainly be more advantageous if losses are being used to offset short-term gains or regular income, or if the losses are sufficient to reduce your overall tax bracket. What can be widely agreed upon is that you should actively monitor the status of your realized gains and losses throughout the year so there are no surprises at tax time. Even if you haven’t sold an asset, you still need to check your realized gain/loss status. Sometimes corporate reorganizations and mergers or mutual fund distributions can cause gains to be “realized” even though the security wasn’t liquidated. Also, capital gains on stocks that are sold can be significant even in a flat market year. This is especially true the longer the bull market lasts. For instance, the current stock market has been increasing in price for well over six years. If assets were sold this year, there could be a significant tax liability even though the overall portfolio value hasn’t changed much over the last 12 months.
If you have large gains and think tax loss selling might be an appropriate strategy, consider the pitfalls noted above and discuss the idea with your accountant and/or investment advisor before taking action. Tax loss selling in most cases represents only a deferral of capital gains. If you are looking to avoid capital gains entirely, there are only a couple of options. You can hold the stock for your lifetime and then pass it to your heirs on a stepped-up basis or you can donate the appreciated stock to a qualifying charity. In the case of a charitable donation, you avoid paying tax on the entire capital gain and you get to deduct the current value of the asset (provided the asset has been held for more than one year).
Whether or not to harvest tax losses is highly dependent on the individual investor’s tax situation and shouldn’t be something that is automatically done on a regular basis, or even every year-end.
The benefits must always be weighed against the potential drawbacks. While it may seem like a good strategy from a tax perspective, when it comes to your portfolio, you should always be wary of letting the tax tail wag the investment dog.
N. Denise Falkner, CFP ®, Vice President of Operations, Stack Financial Management, November 2015
