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Finding ways to provide better overall after-tax gains

As investment advisors, we are constantly looking for ways to provide any additional performance in client portfolios. As a tax attorney, I know there are a variety of actions an investor can take during a tax year to avoid or defer—but never evade—taxable investment income. One such technique is called tax-loss harvesting, or maximizing losses to provide a better overall after-tax gain.

In theory, it is quite simple. If you buy Stock A for $100 and it declines in value to $90, why not sell it, harvest the $10 tax loss and "bank it" to offset $10 in taxable gains from other investments? And if you still have a loss at the end of the calendar year after doing so, then you can deduct your losses—up to $3,000—against other income on your federal tax return and carry over excess losses to future years.

down arrow woman at clear board
Jamie Grill | Getty Images

In practice, it is far, far more complicated. If selling a security to take a loss were the good you've accomplished, the bad would be that you've lost the opportunity to benefit when the stock recovers its loss. But the Internal Revenue Service doesn't allow you to sell the stock, take the loss and immediately buy the stock back. That would be too easy. Portfolio-cleansing "wash sale" rules prohibit you from buying a "substantially identical" security within 30 days from the date of the sale of the security used to generate the loss.

There are many complex and intertwined tax rules and investment considerations in working this strategy. You don't want to run afoul of IRS laws or turn your portfolio into a tax-efficient mess that now no longer resembles your intended investment strategy.

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For example, many investors have carefully crafted a thoughtful asset allocation. Selling a security that overweights or underweights an area of the allocation can cause far more investment damage than tax gain. Remember, by definition, you are selling when the security is at a loss, so you really want to be around when there is a rally back. This strategy is not about market timing, since you don't know when the loss recovery will happen.

If you would like to explore this tax-deferring strategy, let's consider when it works best and then let's build your toolbox of what you'll need to do to implement it properly.

"Tax-loss harvesting is a wonderful way to find a silver lining in the black cloud of investment losses."

First, this strategy tends to do well in periods of volatility. Sharp movements in the market—say, during inevitable periods of volatility and correction—make this strategy both particularly effective in producing big deferral results and worth its complexities.

When does it not serve you well? When you are in a low capital gains tax bracket this tax year but expect to be in a higher capital gains tax bracket in later tax years, when you might harvest the deferred gains achieved from the harvested losses. There are three tiers of rates for long-term capital gains on investment securities: 0 percent, 15 percent and 20 percent. (Net short-term capital gains—for assets held under one year—are taxed at your ordinary income tax rates.) Consider when you'll be in which tier.

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For investors with increasing income, also consider whether the additional Medicare tax surcharge of 3.8 percent may apply to you later, further increasing your capital gain tax bracket.

Now the tool box of rules and tips:

  • Document the precise tax basis of each purchase of each of your securities to know which lots provide worthwhile tax loss harvest opportunities.
  • Research and select a replacement for the harvested security, that is similar to the one sold and meets your investment criteria. It might track a highly correlated index to the security sold, for example. But remember, if the investment loss you deducted recovers within 30 days of the purchase of the replacement security, you'll need to hold the replacement at least one year or you will have a dreaded short-term capital gain upon its sale. Epic fail otherwise.
  • Buy and sell in the same day so that you don't lose any investment exposure to the market. And watch out for trading costs, commissions and redemption fees.
  • You can't get around the "substantially identical" rule by selling in your personal taxable account and buying it in your IRA. All of your accounts, and your spouse's, will be scrutinized for wash sale rule violations.
  • Unintended consequence: You could turn qualified dividend income, taxed at capital gains rates, into ordinary income if you hold the new security for, generally, fewer than 60 days from when the dividend is received.
  • Record-keeping is key. Calendar and carefully track the tax basis of each lot owned, with buy date, sale date and replacement security. Make sure your broker's records match yours, or the annual 1099B tax reporting form won't reflect your records and planning. Not all brokers' websites track mutual funds by buy lots, so that may not be your best record-keeping system.

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Tax-loss harvesting is a wonderful way to find a silver lining in the black cloud of investment losses. Roiling markets will always give you investment and tax opportunities; take this tax one, but thoughtfully and with great attention to the details and rules.

—By Grant Rawdin, founder and CEO of Wescott