Tax Loss Harvesting

The following is an excerpt on Tax Loss Harvesting from the 2014-Q4 newsletter we recently sent to our clients.

Clients with taxable accounts may have noticed increased activity in late-December. This is an annual strategy called tax loss harvesting. Tax loss harvesting is a confusing yet valuable tool we use to shift your taxes into the future and increase your long-term wealth. In essence, if your portfolio is a field of wheat, then every December we go through and pull up the weeds.

It’s important to understand the rationale because from the outside it just looks like we’ve planted you a crop of weeds. When you sell a stock or mutual fund, you realize a gain or loss. When you realize a gain, you owe taxes. When you realize a loss, you can use that loss to offset realized gains. If your losses exceed your gains, then you can reduce taxable income (up to $3000). You can bank any realized loss that remains for future years, either to offset future realized gains or taxable income.

One wrinkle is where to put the proceeds of the funds we sell? The IRS has a “wash-sale rule” that prohibits realizing losses when you buy a substantially identical asset within 30 days. For some funds we sold, we identified a similar fund that we are comfortable holding long-term. For other funds we sold, we moved money to a low-cost index fund to keep asset class exposure consistent, and then we will rebuy the old fund after 30 days.

One more note: this year was a particularly important year to do tax loss harvesting. For the first time in years, many mutual funds had large capital gain distributions. When a mutual fund trades in and out of stocks during the year, it may realize gains. Legally, it must pass any net gains to its investors. In years past, there were enough losses from the recession to offset gains. This year, most funds ran out of losses and had to distribute capital gains. In this and other ways, 2014 was a painful year for taxes.