It's about as traditional as putting up your holiday themed decorations, having the holiday office party, and exchanging gifts. For investors, tax loss harvesting has been a December tradition for as long as they've been an investor, and to say anything negative about it could make you the Wall Street Grinch. As an investor you should always have data to back up your decision. We'll look at whether the data supports the stated benefits of tax harvesting. (To learn more, read Tax-Loss Harvesting: Reduce Investment Losses.)
TUTORIAL: Investing 101
What Is It?
Not too up on this whole tax loss harvesting thing? Let's say in 2011 you were absolutely sure that gold was going to $2,100 so when it hit $1,900 you pulled the trigger on some shares of SPDR Gold Shares (ARCA:GLD), the most popular exchange traded fund (ETF) that tracks the price of gold. Your call hasn't materialized so you you've lost $2,000 on that position. You're still sure it's going to push through the $2,100 level so you would really like to hold on to it, but you've had a good year and you have $8,000 that are subject to capital gains taxes.
Here's your plan. You're going to take your loss on your GLD position and put the $2,000 against your $8,000 in gains so you only have to pay taxes on $6,000 of capital gains. You know you have to avoid something called a wash-sale rule that doesn't allow you to sell and immediately repurchase GLD so you may put your money to work somewhere else for 30 days and then reinvest in GLD after that. That's tax loss harvesting. (For related reading, see Selling Losing Securities For A Tax Advantage.)
Trying to beat the system is often a fool's game and in the case of tax loss harvesting, that may be true. The Wall Street Journal took on the role of the investing Grinch when they looked at how well tax loss harvesting actually works. They found that it wasn't as much of a gift under the tree that some people think.
Tax expert Kent Smetters is a professor of risk management at the University of Pennsylvania's Wharton School and cites a few of the normal culprits that remain a thorn in the side of investors: inflation and tax rates.(Check out Timeless Ways To Protect Yourself From Inflation.)
Because tax loss harvesting isn't removing your tax liability, you're going to pay the taxes sometime in the future. When you sold your GLD position at a loss, you lowered your entry point, or tax basis by $2,000 for the next position you open.
Later on, presuming your call of $2,100 gold comes to fruition, you now owe that extra $2,000 that you harvested in 2011 and you'll pay the taxes on that gain at what could be a higher tax rate and using dollars that are worth less in the future than they are today. All of that, according to Smetters adds up to minuscule savings, if any at all.
The Bottom Line
Smetters' analysis doesn't suggest that all tax loss harvesting is ill advised. Investors along with their financial and tax advisers should instead carefully consider and calculate the potential savings involved in this strategy instead of believing conventional wisdom. (To learn more about tax offsetting strategies, read 7 Year-End Tax Planning Strategies.)