Portfolio Management Includes Being Aware of Potential Tax Savings

I wrote last month about how capital gains and losses work. Year-end, however, is not a time to get complacent with your investment portfolio. On the contrary, as the calendar gets closer to turning to a new tax year, there are still potential benefits that can be reaped.
I’m referring to tax-loss harvesting, and I’d like to consider realized investment gains and losses through this prism. If you’re not actively tax-loss harvesting your portfolio, you either:
A. Hold no positions at a loss in your nonqualified
     portfolio or

B. Are missing an opportunity to reduce your current
     and/or future tax burden.

Tax-loss harvesting refers to selling investments held at a loss in a nonqualified portfolio to offset realized capital gains. Tax-loss harvesting is almost as simple as it sounds; there are, however, a few details to understand.

What Are the Potential Benefits?

Capital loses can be used to offset capital gains dollar for dollar. For example: You have long-term gains of $20,000. Assuming you’re taxed at 15% on long-term capital gains at the federal level, you would owe $3,000 in tax. If you’re able to recognize $18,000 in losses before year-end, the $20,000 long-term gain is offset by the $18,000 capital loss, so you’re left with a $2,000 long-term gain at year-end. At the same long-term gains tax rate, taxes owed are now $300 instead of $3,000.00 — which means $2,700 extra in your pocket come April!

Do You Understand the Nature of Your Unrealized/Realized Gains and Losses?

When the time comes to offset gains and losses, short-term gains are offset against short-term losses and then long-term gains are offset against long-term losses. Finally, the net effect of the short-term gain/loss is offset against the net effective of the long-term gain/loss to derive your total gain/loss for the year.

If you end the year with a capital loss, you’re allowed to offset income by the lesser of $3,000 (if you file a joint tax return, $1,500 if filing single/separately) or the net loss. Any net loss beyond $3,000 can be carried forward into future years to offset capital gains. Capital loss carryforwards do not expire.

The Wash-Sale Rule

One pitfall to be aware of is the wash-sale rule. Per Internal Revenue Service rules, a wash sale is triggered if you wait less than 30 days from the day the loss was realized before repurchasing the investment or a substantially similar investment. This goes beyond the account from which the investment was sold. If you recognize a loss in your trust account but repurchase the same investment within 30 days in your spouse’s individual retirement account, a wash sale would be triggered. If a wash sale is triggered, the loss will be disallowed. The rule is meant to discourage investors from churning their portfolio to rack up losses.

Avoiding a wash sale does not mean you need to sit in cash for 30 days. You could even maintain subsector exposure by selling an individual stock and buying an exchange-traded fund. For example: you could recognize a loss in The Boeing Company (ticker: BA) and purchase an ETF that tracks the aerospace and defense subsector. Then after 30 days you can sell the ETF and repurchase BA. There are countless examples of how effective tax-loss harvesting can be accomplished in an investor’s portfolio.

I like to think of tax-loss harvesting as “making lemonade out of lemons.” No investor likes to see losses in a portfolio, however, appreciating the value that tax-loss harvesting can have is necessary to optimal portfolio management. As always, your individual tax situation is important in any decision surrounding tax-loss harvesting. You should consult with your adviser or tax professional if you want to understand your specific tax impact.

This article was originally published in the December 2020 issue of BetterInvesting Magazine.

Matt Mondoux sits on the investment committee and is an adviser at Blue Chip Partners ,Inc., a privately owned, registered investment advisory firm based in Farmington Hills, Michigan. Visit www.bluechippartners.com.

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