J.D. is on vacation. This is a guest post from Linden Cornett. Linden is a Portland-area professional with an interest in finance.
The stock market is down this year, and many people have asked me if I've made any changes to my investments as a result. My general strategy is to buy-hold-rebalance my stock and bond investments, so I've mainly used this downturn as an opportunity to buy stocks at bargain prices.
There is one tax strategy that I'd recommend to anyone who has losses in a taxable account. I've already done this with a few of my investments, and maybe you should too. The strategy is known as “tax-loss harvesting”, and here's how it works.
Suppose you have an investment with a cost basis of $10,000, and its current value is $5000 (certainly possible given the stock market's performance this year). Let's assume that in two years from now, the value of your investment would return to $10,000. If you do nothing, you'll have a $10K investment in 2010 and owe no taxes if you were to choose to sell it at that time.
If, instead, you sell your investment this month, wait 31 days, and then buy it back, you'll be able to realize the $5000 loss on your 2008 tax return.
During those 31 days, you might choose to invest in a money market fund or some similar investment so that you don't miss out on a possible upswing in the market during that 31-day period — more on that later. Assuming no significant market movements during the 31 days, you'll still have a $5000 investment. In this case, what have you gained?
Offsetting capital gains
First, the $5000 loss on this year's tax return can be used to offset any other capital gains you might have realized this year. If you don't have any capital gains this year, then you can use the first $3000 worth of losses to avoid paying taxes on current-year income. Any amount over $3000 can be carried forward as capital losses towards your tax returns in future years. The losses can be carried forward indefinitely and used to offset $3k of income each year or to offset future capital gains.
But what about your investment, which used to have a cost basis of $10,000 and now has a cost basis of $5000? When you sell this investment at some point in the future, won't it be a wash since you'll have to pay taxes on an extra $5000 of investment gains? Although future tax rates are an unknown, we are making two assumptions here:
- The first is that capital gains tax rates will continue to be lower than income tax rates.
- The second is that we'd prefer to defer paying taxes (after all, isn't this why we invest in 401(k) plans?).
Current capital gains tax rates are 0% for those people in the 10% and 15% income tax brackets. For people in the 25% and higher income tax brackets, capital gains are taxed at 15%.
If a person in the 25% tax bracket takes a capital loss of $5K this year, she can reduce this year's taxable income by $3000 and next year's taxable income by $2000. Disregarding state taxes for a moment, she would save $750 this year and $500 next year on federal taxes, for a total savings of $1250.
If she decides to sell her investment with a long-term gain of $5000 in 2010, she will pay $750 in capital gains taxes, for a net savings of $500. If she waits until retirement to sell the investment, which may be decades away, the current savings of $1250 may be compounded over a long period of time.
The waiting game
What should you do with your investments during the 31-day period before you can buy them back? One option is to simply let your cash sit in a money market fund. It will earn a guaranteed interest rate and will be safe from losses. The downside to this choice is that you may miss out on an upswing in the market. With the current levels of volatility in the market, bad timing could mean you'll miss a significant rally.
Another option is to temporarily invest your money in a similar investment. For example, if your money is currently in the Vanguard Total Stock Market Index (VTSMX), you could swap over to the Vanguard 500 Index (VFINX) for 31 days, and then swap back. This way, you'll still earn the same approximate market return that you would have earned had you done nothing.
The downside to this choice is that you may lose money during the 31-day period. Also, if the market does go up, you'll have a short-term gain, and you'll have to pay taxes on that gain.
Each investor needs to decide for herself which option makes sense for her particular situation and temperament. You may also choose to use this opportunity to change your portfolio if your current investments are not the ones you'd like to hold for the long term.
Playing by the rules
To make sure that your tax-loss harvesting meets IRS requirements, you must refrain from buying any shares of your investment, or a “substantially identical security”, for the 30 days before and the 30 days after selling it at a loss. This is known as the “wash-sale rule”, and it is the reason for waiting 31 days after selling your investment before buying it back. Make sure that you have not purchased any shares of the investment during the 30 days prior to selling as well.
A “substantially identical security” is a little bit of a grey area. It is certainly not allowed to sell shares of a particular stock and then buy back the same stock within the wash-sale time period. Selling shares of one S&P 500 fund and buying a different S&P 500 fund for 31 days is unlikely to cause an issue, but you're probably better off swapping into funds with somewhat different holdings.
Not for everyone
For people in higher tax brackets, or with larger losses, the benefit increases, although it may take many years to whittle away at the carried-forward loss at a rate of $3000 per year.
For some people, this strategy may not make sense.
- For example, if you only have small losses, it is probably not worth the effort since this strategy does require a bit of work. It's probably only worth it if the losses are a significant dollar amount to you (each person has a different definition of “significant”).
- Also, if you would have to pay fees and/or commissions in order to buy and sell, it may not be worth making any changes (this is yet another reason to invest in no-load mutual funds).
- Finally, if you are in a low tax bracket now, but expect to be in a higher tax bracket in retirement, the benefit decreases or vanishes.
This has been a brutal year for stock and bond investors. Many of my friends and family have called me in a panic asking if now is the time to abandon the stock market. My advice to stick with their investment plan is not always what they'd like to hear, so it is helpful to be able to recommend tax-loss harvesting as a concrete way to benefit from capital losses.
In addition, there is a psychological benefit to doing something, and this is a more beneficial tactic than changing your investment plan as an emotional reaction to a disappointing year.
Photo by Linden Baum.