Another year has come and (almost) gone. While your spirits may be full of holiday cheer (and egg nog), this is no time to forget about your financial goals. Depending on what part of the year you did your investing, you could have some losses in your taxable accounts that you can harvest for a tax break. (For related reading, see: Tax-Loss Harvesting: Reduce Investment Losses.)
Take Advantage of Tax-Loss Harvesting
When you sell a stock, bond or mutual fund, the difference between what you paid to purchase it and your net earnings is considered a gain if the amount is positive or a loss if the amount is negative. In most cases, you would certainly hope for gains, not losses. However, some investors strategically use losses to negate the effects of capital gains taxes. Capital gains are taxed at 15% on long-term gains (anything held over one year); short-term gains (held less than one year) are taxed at your ordinary income tax rate. (For related reading, see: What You Need to Know About Capital Gains and Taxes.)
Any gains realized during the year can be offset by selling losers. This is what we call tax-loss harvesting. Regardless of whether the gain is short-term or long-term, the loss will counteract the gain. What’s more, if you are able to realize more losses than gains this year, you are able to carry forward up to $3,000 of losses to next year, which can save you on taxes. Note: if you are planning on doing this, please consult your CPA or a tax professional to make sure this strategy makes sense in your specific situation.
During the year, perhaps you sold a security to have the extra cash to replace your hot water heater, for example. Often when the money is needed, capitals gains are disregarded, which is why the holidays are a perfect time to review all transactions from the year and see where you stand on gains taxes. Most brokerages offer a convenient way to view this: in your accounts, there should be a tab that shows “Realized Gains/Losses.” Make sure to look at the “Realized” tab rather than “Unrealized.” That ensures you’re looking at the investments you sold during the year instead the “what ifs.” (For related reading, see: How Are Realized Profits Different From Unrealized or So-Called "Paper" Profits?)
So, what do you do after you sell, you may be wondering?
Be Aware of the Wash Sale Rule
There are a few options, depending on whether you plan to re-deploy the capital elsewhere or hold it in cash. For example, it is possible to use the newly freed funds to re-balance back into underperforming funds according to your asset allocation. However, what you certainly want to keep in mind is something called the wash sale rule. If you sell securities at a loss, in order to get a tax benefit from that loss, you cannot invest in a substantially similar investment for at least 31 subsequent days.
The keywords are "substantially similar." Arguably, there are funds that perform similarly, but are not exactly the same, where you can park the money for a bit. You don’t have to re-invest the money at all (you could leave it in cash), but some investors like to keep their money working for them in the market for as long as possible. Each situation is unique, and what’s important to know are the different options you have.
Regardless of what you decide, be aware of how you classify any tax-advantaged dividends, as reinvesting of any kind back into the fund you sold out of at a loss will flag it as a “wash sale.” It doesn’t matter if you sold VTSAX in your taxable account and accidentally had dividends reinvested in your VTSAX holding in your 401(k) within 30 days. That will negate the tax benefits of harvesting the loss.
At the end of the day, there are plenty of things to do around the holiday season. Most of them cost money. Why not add something to your list that could potentially save you money? (For related reading, see: Wash Sales and Substantially Identical Securities.)