Tax Loss Harvesting

For many investors, tax loss harvesting is the single most important area for reducing taxes now and in the future. If properly applied, it can save you taxes and help you diversify your portfolio in ways you may not have considered. Loss harvesting is the process of selling securities at a loss to offset a capital-gains tax liability.

Investors usually think about selling their losing stocks or mutual funds at the end of the year to realize losses that can offset capital gains realized earlier in the year. If you’re managing your portfolio tax efficiently and you harvest tremendous losses, you might not pay capital gains taxes for many years.

Generating a tax loss is like making lemonade out of your stock market lemons, but there are limitations. Here’s a big one: You can’t take a tax loss on an investment in a tax- sheltered retirement plan, including individual retirement accounts and 401(k) and 403(b) plans. It only makes sense to harvest losses in taxable accounts.

If your investing losses exceed your total gains, you can use any remaining losses — regardless of their short or long-term nature — to offset up to $3, 000 a year in ordinary income, including wages, dividends and interest. Any losses beyond that can be carried into future years to offset capital gains, then ordinary income.

What if you’d like to generate a tax loss but think the market may be close to a bottom and don’t want to be out of the market during the upswing? Here’s the beauty: You can sell one security and simultaneously buy another one that is similar without jeopardizing your tax loss. This essentially allows you to reap the rewards of loss harvesting without any impact on your investment performance. But, be aware that if you repurchase the same security or one that is “substantially identical” within 30 days, your tax loss will be disallowed under the wash sale rule.

This strategy is fairly easy with mutual funds, especially generic no-load funds that are part of a big family or in a fund supermarket. For example, you could sell shares in an S&P 500 index fund and buy shares in another family’s S&P 500 index fund without violating the wash sale rule. IRS Publication 564, Mutual Fund Distributions, Page 8, states: “Ordinarily, shares issued by one mutual fund are not considered to be substantially identical to shares issued by another mutual fund.”

Another option is to sell shares in an S&P 500 index fund and buy shares in an exchange-traded fund such as the Standard & Poor’s Depositary Receipts (also know as Spiders) or the IShares S&P 500 Index Fund.

If you own shares in a mutual fund that charges a load, you might have to pay commissions when you sell shares in one fund and buy another. Some load-fund groups will waive commissions if you switch between funds in the same family. If they won’t, the sales fees might outweigh the benefits of loss harvesting.

You should never make a decision based solely on tax considerations. With loss harvesting, you have to have a pretty clear idea what you’re going to use those losses against, there are issues of fees, timing, and you have to be very careful you’re buying something similar to what you’re selling.

But, if you have losses, there may be no reason not to lock in those losses. If you’re using no-load funds it could cost you nothing to do the harvesting, and you lock in the loss indefinitely.