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.)

The Problem
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.)

Related Articles
  1. Investing

    In Search of the Rate-Proof Portfolio

    After October’s better-than-expected employment report, a December Federal Reserve (Fed) liftoff is looking more likely than it was earlier this fall.
  2. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  3. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  4. Taxes

    Tax Breaks For Volunteering

    Your volunteer ventures could earn you some welcome tax deductions, along with the satisfaction of helping others.
  5. Taxes

    Six Ways Your Tax Preparer Knows You’re Lying

    Cheating on your taxes is asking for trouble. You might get away with it, but you’re playing with fire and likely to get burned.
  6. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  7. Professionals

    A Day in the Life of a Hedge Fund Manager

    Learn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end.
  8. Entrepreneurship

    Creating a Risk Management Plan for Your Small Business

    Learn how a complete risk management plan can minimize or eliminate your financial exposure through insurance and prevention solutions.
  9. Taxes

    How & Where to File Form 1040 (And Which Version)

    All taxpayers need to know three things when filing a 1040: which form to use, how to file and where to file. After reading this, you'll know all three.
  10. Savings

    Should You Look at 529 Plans Outside Your State?

    529 savings plans are not restricted by geography. So if your in-state offering has high fees or poor investment choices, look elsewhere.
  1. Are secured personal loans better than unsecured loans?

    Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
  2. Do tax brackets include Social Security?

    A portion of your Social Security benefits may be subject to federal taxation using tax brackets. Your tax bracket is determined ... Read Full Answer >>
  3. Are personal loans tax deductible?

    Interest paid on personal loans is not tax deductible. If you take out a loan to buy a car for personal use or to cover other ... Read Full Answer >>
  4. Do 401k contributions reduce AGI and/or MAGI?

    Traditional 401(k) contributions effectively reduce both adjusted gross income (AGI) and modified adjusted gross income (MAGI). ... Read Full Answer >>
  5. Is homeowners’ insurance tax deductible?

    While your fire or homeowners' insurance premiums may be included in your property payments, they are nondeductible expenses, ... Read Full Answer >>
  6. Do financial advisors charge VATs?

    The Personal Finance Society (PFS) and with Her Majesty's Revenue and Customs (HMRC) have outlined when a value-added tax ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center