Volatile markets are challenging to endure as an investor. We feel that acutely during times of uncertainty, no matter our years of experience or our understanding of investment portfolios. During times of stress, it’s helpful to look to what we can control. And in the context of investing, this can also reveal opportunities.
Depressed market valuations offer creative investors opportunities to capitalize. For those finding themselves in a low income, low tax environment with retirement assets invested in equities, a Roth conversion may be in order. For investors with taxable investment accounts, there is another strategy to consider carefully: tax loss harvesting.
The Benefits of Tax Loss Harvesting
The practice of tax loss harvesting involves selling out of positions that are trading at losses while simultaneously buying similar investment strategies in order to maintain comparable asset class exposure.
Booked losses help mitigate taxes in a few ways:
- Offset capital gains that have already been realized during the calendar year
- Offset capital gains that might be realized later in the calendar year
- If a taxpayer realizes more losses than gains at year-end, these can be used to offset up to $3,000 of ordinary income.
- To the extent that losses are remaining after offsetting $3,000 of ordinary income, they will carry over into future years.
At what point should you consider harvesting a loss—at a specific dollar amount or a specific percentage decline in a position? The answer is: it depends.
You want to factor in things like transaction costs and real dollars saved. If you have a $1,800 loss and pay capital gains taxes at 15 percent, that’s $270 of potential value. If the buys and sells cost $40, you can see that there is not enough benefit to justify the trades. However, if you are looking at an $18,000 loss, that math changes 10-fold.
There should also be strong consideration for the second half of the harvest: buying back into similar investment strategies simultaneously. Do you have an appropriate alternative option? Are you comfortable holding that option long-term? What about a third option?
If you have good alternatives, then you might set lower thresholds to harvest. You could harvest into a 5-10 percent decline and be able to harvest once or twice more if markets continue to go down. The key is not running out of substitutes.
The purpose of setting a dollar threshold is to ensure the loss will be meaningful to your tax return. The purpose of setting a percentage threshold is to ensure the loss is meaningful relative to the type of volatility we expect when investing in equities or other market segments.
A Case Study on Harvesting Losses
Let’s look at an example. A starting threshold for considering harvesting losses in equities might be $6,000 and a six percent loss. For a U.S. total stock market fund, harvesting losses at this lower threshold makes sense as you can move from Vanguard’s Total Market Index to iShares Total Market Index to the Schwab US Broad Market Index, etc. Given the range of options, you’re unlikely to run out inside of a 30-day window.
On the other hand, harvesting losses in a niche market segment like global real estate may be more challenging. You are better off waiting until losses are more meaningful. If you own SPDR Global Real Estate, which invests in a combination of domestic and international real estate investment trusts (REITs), it might make sense to wait for a 12 percent loss. This is because there are fewer REIT funds than U.S. total stock market funds. You may have to split your purchase into two separate funds: a domestic REIT fund and an international REIT fund.
Maintaining market exposure is crucial. Tax mitigation is important and can provide significant benefits to a financial plan. Still, it pales in comparison to the risk of being out of the market and missing rebounds and recovery. Do not turn tax loss harvesting into a market timing play. The jury is in on market timing, and it doesn’t work.
Consider Your Tax Situation
Your personal tax situation plays a role as well. Did you realize gains earlier this year that you are specifically trying to offset? Or do you have a concentrated position—like in your company’s stock—that has significant embedded capital gains? If so, you might take a more aggressive stance than an investor simply trying to take advantage of undefined tax mitigation in the future.
As with most things, smart execution plays a big role in having a successful outcome.
In volatile markets, you must be diligent about calculating appropriate buys for your replacement funds with large intra-day pricing swings. You don’t want to end up with a canceled trade due to insufficient funds or incurring margin interest.
Beware too of losing the benefit by trading too frequently. The wash-sale rule was designed to discourage investors from selling securities at a loss simply to claim a tax benefit. A wash sale occurs when you sell a security at a loss and then purchase that same security or “substantially identical” securities within 30 days either before or after the sale. This might mean buying back the same fund or the same fund in a different share class.
One Strategy in a Larger Plan
While this is an attractive opportunity to achieve some benefits during down markets, anything dealing with taxes is highly nuanced. It is important to keep in mind that each circumstance is unique, and harvesting losses applies differently to different income levels and account structures. In certain instances, it may be more advantageous to harvest gains.
As with all investment strategies, do adequate research to ensure that you are achieving the desired benefits without adding risk to your portfolio. Having a Personal CFO on your team can ensure that all angles are considered, all bases are covered, and that execution is flawless.
If you are interested in learning more about how a Personal CFO can help you maximize opportunities in your portfolio, we would love to talk.
Matt Mormino, CFP® serves as an advisor at Brighton Jones.
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