STA Weekly Report – Tax Loss Harvesting Season is Upon Us
Written by Luke Patterson | Friday, November 8th, 2019
INSIDE THIS EDITION: Tax Loss Harvesting Season is Upon Us Weekly Snapshot of Global Asset Class Performance Recession Survival Guide 401k Plan Manager
With only a few weeks until Thanksgiving, the tax-loss harvesting season is once again upon us. While this year has been marked by strong gains across most asset classes, it is still important to review accounts for opportunities to harvest potential losses because depending on specific entry points across asset classes, the total return picture could be significantly different.
This is what is often referred to as a sequence of return risk and is most often cited over many years like the table below shows. However, this sequence of return problem can also manifest on an intra-year basis.
While “paper losses” are certainly not a pleasant experience during a period when equity markets have generally moved higher, investors should consider taking advantage of tax-loss harvesting opportunities where they exist. Tax-loss harvesting is a practice of realizing a loss to offset a gain or income, thereby reducing the current year’s tax obligation. Tax-loss harvesting often occurs in December, with December 31 being the last day to realize a capital loss.
A capital gain or loss is the difference between the cost basis and the sale price. Usually, the cost basis is what you paid for the investment. Any gain or loss is not realized until the investment is sold. There are two types of gains and losses: short-term and long-term. Short-term capital gains and losses are those realized from the sale of an asset held for one year or less. Long-term capital gains and losses are realized from the sale of an asset held longer than 1 year. Short-term capital gains are taxed at marginal tax rates on ordinary income. The top marginal federal tax rate on ordinary income for 2019 is 37%, just like it was last year.
Long-term capital gains tax rates, on the other hand, are 0%, 15% or 20% depending on your taxable income and filing status. Regardless of your tax bracket, tax rates for long-term gains are generally much lower than those for short-term capital gains.
As a part of prudent investment planning, tax-loss harvesting can effectively reduce the tax-drag on the performance of a portfolio and provide a way to improve after-tax returns. However, to accomplish this the strategy must be implemented correctly.
For example, let’s assume Mike has a $1,000,000 portfolio held in a taxable account. By the end of 2019, Mike has recognized $100,000 worth of long-term capital gains. Without making any further transactions, Mike has a capital gains tax liability of $15,000, assuming his long-term capital gains tax rate is 15 percent. The good news for Mike is that tax-loss harvesting can reduce this liability. For example, Mike might sell some stocks and bonds that experienced $50,000 in losses. If he sells those securities, the net gain can be reduced from $100,000 to $50,000. In this scenario, harvesting tax losses would save Mike $7,500 in taxes.
According to the tax code, short- and long-term losses must be used first to offset gains of the same type. But if losses of one type exceed gains of the same type, then excess losses can be used to offset the other type. Therefore, the most effective tax-loss harvesting strategy is to apply long-term capital losses to short-term capital gains. In the previous example, if Mike’s $100,000 gains are short-term and taxed at 37%, harvesting the same $50,000 in losses would save $18,500 of the current year’s tax liability.
As you can see from this example, a tax loss harvesting strategy needs to be carefully implemented. When selecting securities that have lost value for sale, investors need to be mindful not to deviate from their target asset allocation and diversification strategy. Most investors may choose to repurchase the same investment to maintain the proper asset mix. However, they must be careful of wash sale rules, which prohibit repurchasing a “substantially identical” security within 30 days before or after the selling date.
It is important to note that the tax savings from tax-loss harvesting in a given tax year can overstate the true gains. Selling an investment at a loss and subsequently using the proceeds to purchase the same or similar security effectively resets the cost basis at a lower value and increases the imbedded tax liability. If the security repurchased and then sold in the future, investors need to pay the taxes that are being saved today through tax-loss harvesting. Put another way, the economic value of tax loss harvesting is largely a tax deferral rather than elimination of tax liability.
However, the postponed tax payment of appreciated securities is still extremely valuable in many ways.
First, the time value of money tells us that one dollar today is worth more than one dollar tomorrow. For example, if a $10,000 tax payment can be postponed for 5 years, an investor can simply set $9,000 on the side, invest in a 5-year risk-free treasury bond that returns 2% per year and receive $10,000 in 5 years. So, he effectively pays $9,000 rather than a $10,000 tax in current dollars.
Second, the tax payment is a real cash outflow from an investment portfolio. By realizing a loss, an investor can save taxes in the current year, which increases the amount of capital available for investment. To some extent, this is analogous to a dividend reinvestment plan (DRIP). In a DRIP, the investor does not take quarterly dividend distributions as cash; instead, dividends are directly reinvested in the underlying stock. The power of dividend reinvestment is manifested when it is compounded over long time horizons. Similarly, the longer an investor can defer the realization of capital gains and the higher tax rate on capital gains, the more the investor will benefit from tax-loss harvesting.
Third, financial assets like stocks and bonds can receive a step-up in basis when an asset is passed on to a beneficiary upon inheritance. The step-up in basis readjust the value of an appreciated asset for tax purposes and therefore potentially eliminates the embedded capital gain liability altogether.
Fourth, donating highly appreciated securities can be a very tax-efficient way to support a philanthropic purpose. A donor not only can deduct the full fair market value of appreciated long-term assets held for more than a year, but he or she avoids paying capital gains taxes on those securities.
Lastly, if capital losses exceed capital gains in a given
year, an investor can use up to $3,000 of losses a year to offset ordinary
income in future years.
To sum things up, tax loss harvesting is an active investment management strategy that potentially improves after-tax returns by deferring capital gains taxes into the future and increasing after-tax capital for investment today. Fundamentally, it reflects the most basic principle of finance – the time value of money. That is, when you save tax money today (loss harvesting) and pay it later, you maximize the net utility of each investable dollar in your portfolio.
Recession Survival Guide
By Scott A. Bishop, MBA, CPA/PFS, CFP®
Over the years, I have written many articles on financial
planning. Several of those have been “guides” to help readers through different
stages of their life or lifecycle events. Two of those were the Retirement
Survival Guide and Layoff
Over the last year or two, I have had many friends and clients ask about the pending “recession”. Many have been waiting for the next one almost every year since the “Great Recession” of 2008. As no one knows for sure when (not if) the next recession will come, I felt that it was time to start considering writing a “Recession Survival Guide”. As I have written many of the components that I will eventually reference in that guide, I thought I would start out with this article sharing some thoughts, pointers, and guidelines that may help you find good solutions for you and your family.
The bottom line, for any risks in life you need to address, you
should have a plan – don’t react. Once a future recession is upon us, many will
react on fear which typically ends in a less than optimal solution. As a
long-time financial planner, I know that having a plan in advance of any unexpected
event will allow you to make optimal decisions to help keep you and your family
on track to your longer-term financial goals and objectives. With that in mind,
here are some thoughts and linked articles for your consideration to help you
“survive” any future recession.
Planning and Investment Advice offered through STA Wealth Management (STA), a
registered investment advisor. STA does not provide tax or legal advice and the
information presented here is not specific to any individual’s personal
circumstances. To the extent that this material concerns tax matters or legal
issues, it is not intended or written to be used, and cannot be used, by a
taxpayer for the purpose of avoiding penalties that may be imposed by law. Each
taxpayer should seek independent advice from a tax professional based on his or
her individual circumstances. These
materials are provided for general information and educational purposes based
upon publicly available information from sources believed to be reliable—we
cannot assure the accuracy or completeness of these materials. The information
in these materials may change at any time and without notice. As always, a copy
of our current written disclosure statement discussing our services and fees
continues to be available for your review upon request.
Thank you for your interest in STA Wealth Management!
Whether you are looking for someone to partner with you in protecting and growing your assets, or you are an experienced financial advisor interested in joining the STA team, we want to hear from you. Please call us or email us, and we’ll be in touch as soon as possible!
CityCentre One 800 Town & Country Boulevard, Suite 410
Houston, TX 77024