Summer is winding down. And believe it or not, 2012 is more than half way over, which means it’s a good time for investors to start thinking about the year-end tax implications of their portfolios.
We invited Steve Thorpe, Founder of Pragmatic Portfolios, LLC to share some insights on Tax Loss Harvesting. Enjoy.
Tax Loss Harvesting: Why Should You Care?
Would you invest a few hours to reduce this year’s taxes by $1,000 or more?
For investors with taxable investment accounts, this is often possible by taking advantage of tax loss harvesting (TLH). This perfectly legal strategy makes lemonade from lemons, allowing Uncle Sam to share part of the pain of the losses inevitably experienced by investors at some points during their investing career.
Between now and the end of the year is a good time to review your portfolio to see if any of your holdings are in the red. If so, you might be able to use those losses to help lower your tax bill.
TLH can result in lower income taxes during the current or future years, and/or allow an investor to sell other securities that have gone up in value without incurring as high a tax bill.
Tax Loss Harvesting: What it is and How it Works
From time to time, an investment will fall below its initial purchase price. If it’s held in a taxable account then this could be a TLH opportunity. TLH entails selling the underwater security to realize the loss, and then buying a similar but not substantially identical security to replace it (assuming it makes sense given an individual’s personal tax and asset situation).
TLH can result in lower income taxes and may allow an investor to sell other securities that have gone up in value without incurring as high a tax bill. You can then purchase a similar (but not substantially identical) replacement security to maintain their desired asset allocation.
If you sell a security for less than what you originally paid for it (the “cost-basis”) you have a capital loss. On the other hand, if you sell a security for a higher price that what you had originally paid for it, you then have a capital gain.
Here’s where tax loss harvesting helps: If your overall capital losses exceed your capital gains, the excess can be deducted on your tax return and used to reduce other income (such as wages) up to an annual limit of $3,000 (or $1,500 if you are married filing separately).
If your total net capital loss is more than the yearly limit on capital loss deductions, you can carry over unused short-term and long-term losses to subsequent years, subsequently “using up” the losses year by year until they are gone.
Tax Loss Harvesting: An Example
Let’s say you owned a security for less than one year that you originally purchased for $40,000 and you sold it for $45,000, realizing a gross profit of $5,000. And let’s assume (for example purposes here) that your marginal tax rate (combining federal plus state) is 30%. The good news is that you made $5,000 in the market. The bad news is that (based on the 30% tax rate) $1,500 of your $5,000 (the short-term gain you realized) is cut off the top and sent to Uncle Sam because you pay taxes at your marginal ordinary income tax rate on any gain on securities held less than a year. (Gains on securities held more than a year are taxed at a long-term capital gains rate).
Now, suppose you have another security (also owned for less than a year) which you bought for $50,000 and the security is now worth only $43,000. If you sold the security you could take a short-term loss of $7,000. This $7,000 loss completely off-sets the $5,000 gain, leaving a $2,000 loss that can be deducted against ordinary income on your tax return. The $2,000 loss can be deducted against ordinary income on your tax return and now translates into a $600 reduction in income tax for the year. By booking the loss, you owe $600 less in taxes instead of $1,500—a net savings of $2,100.
Impacts of Potential 2013 Tax Rate Changes
As Election Day draws closer, political rhetoric surrounding the Bush-Era tax cuts will undoubtedly heat up. These tax cuts are set to expire after this year, which means tax rates on long-term capital gains and other tax rates may revert to higher levels. We can’t control the future, and it’s anyone’s guess right now who will win the election and if they will let the tax cuts expire or not. Yet assuming it becomes clear near the end of 2012 that tax rates will go up next year, investors may want to take a look at pursuing tax loss harvesting in early 2013 rather than this year. Postponing TLH is typically not recommended, yet if tax rate increases go into effect this could be a special case. For some investors, it might be worth waiting until January 2013 to realize a loss through TLH—since the “loss” could be “worth” more than through a larger reduction in taxes than if it was taken in 2012. Similarly, investors who were planning to realize a taxable gain in 2013 might benefit from doing so in late 2012 in order to receive a more favorable tax treatment on any gains.
If you have a large TLH opportunity several months before the end of 2012, I wouldn’t wait to book the loss. However, it’s never a bad idea to consult a licensed tax professional to determine a strategy that’s right for you—and your financial circumstance.
About the Author:
Steve Thorpe is the founder of Pragmatic Portfolios, LLC, a fee-only Registered Investment Adviser based in Durham, North Carolina that focuses on developing sensible investment plans integrated across all of a client’s investment accounts. He also chairs the Research Triangle Park, NC area chapter of the “Bogleheads” investment interest group. Observing conflict-of-interest laden behavior of various charlatans from Wall Street has always inspired Steve to help others navigate the sometimes-treacherous investment landscape. Building upon his lifelong fascination with investing, he has been advising clients, business associates, family and friends for years.
Circular 230 Disclosure Notice:
To insure compliance with requirements imposed by the Internal Revenue Service, we inform you that any tax advice that may be contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code or any state or local tax law to which a governmental requirement similar to Circular 230 applies.
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