Financial Planning Tip of the Month
Turning Lemons into Lemonade
At RAA, we believe in being proactive in our investment approach to maximizing returns. Our philosophy includes important steps to include taxes when making investment decisions.
*The following concepts are only effective on taxable/non-retirement accounts.
Strategic Tax-Loss Harvesting could help you reduce your taxes on realized capital gains.
Sometimes an investment that has lost value can be a good thing. You can sell losing investments to reduce taxes on capital gains from winning investments.
That’s called tax-loss harvesting.
We understand that losing money doesn't feel good, but a well-diversified portfolio will usually contain some investments that have lost value. That being said, you should not let taxes dictate your investing strategy. Depending on your specific situation, it may be good idea to consult a tax professional.
The key to an effective tax-loss harvesting strategy is to identify investments that have lost value and then consider the sale of some portion of those holdings to offset existing realized gains. This should be done while being careful not to stray from your target investment mix and diversification strategy.
The first thing we recommend is to estimate your capital-gains tax liability.
Once you have a sense of how much you might owe in capital-gains tax, you can begin looking for opportunities to harvest tax losses. Consider investments that can be easily replaced by other investments that fill a similar role in your portfolio.
It is important to remain diversified and BEWARE OF WASH SALES
After you sell the losing investments, you may want to look at new investments to buy. Be careful not to run into the dreaded wash-sale rule.
The IRS will not allow you to buy back the same security you sold. The wash-sale rule states that your tax write-off will be disallowed if you buy the same security, a contract or option to buy the security, or a "substantially identical" security, within 30 days before or after the date you sold the original investment at a loss.
Fear not! There are ways to avoid a wash sale while remaining invested on the sectors or asset classes that you want to own. Say hello our friend the exchange-traded fund (ETF). Here is an example: Let's say you bought Exxon (XOM) earlier this year at $90. XOM trades around $82 today. You are interested in using the loss to offset some gains this year. However, you still want to maintain an investment allocation to the Energy sector. You CANNOT buy back XOM for 30 days or your loss will be disallowed by the wash-sale rule. You can, however, buy an ETF that invests in Energy companies like Fidelity MSCI Energy Index; FENY or Energy Select Sector SPDR; XLE. Both ETFs have a substantial holding in XOM (23%) along with other big oil names like Chevron and Slumberger. Although some substitutions are allowable, others may come closer to the IRS interpretation of what constitutes a "substantially identical" security. If you’re not sure, you should consult an advisor before making the purchase.
You can also make tax-loss harvesting part of your year-round tax strategy. As you rebalance your portfolio, keep tax loss harvesting in mind. In addition to keeping in line with your target asset mix, rebalancing creates opportunities to improve your tax situation.
If you choose to use tax-loss harvesting, be sure to keep in mind that tax savings should not undermine your investing goals.
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While we are on the topic of taxes, we want to share another important concept...
It's called "buying the distribution" and is something that needs attention when buying or owning mutual funds late in the calendar year.
At first glance big distributions may look like a good thing, signifying the fund made a lot of money. Who wouldn't want to receive $2,500 from a $10,000 investment? It doesn't quite work that way. When the distribution is paid, the fund's share price drops by an equal amount because its assets are reduced. So a $20-per-share fund that pays $5 a share will become a $15-a-share fund, and investors will be no richer the day after the payout than the day before. In fact, the tax bill will make them poorer.
That's why we recommend postponing a fund purchase late in the year until after the payout if a big distribution is expected.
Here is a true example of a mutual fund's year end distribution history over the past 2 years.
The Columbia Acorn USA fund (LAUAX), paid $4.95 on 12/07/2016 and $7.68 on 12/09/2015. Those capital gain distributions were 25% and 27% of the share price! In 2016, if you had $10,000 in the fund, you would have received about $2,500 and had to pay $375 in taxes, assuming a 15 percent long-term capital gains rate. 2016 would have been even worse. Guess what? The fund estimates that the distribution this year will be between 23% and 28%! We are not saying that this is a bad fund. What we are saying is that it is probably not a great choice to own outside of a 401(k) or IRA.
The moral of the story is that mutual funds in general may not be the most prudent choice to own in a taxable accounts. Consider a more tax efficient ETF or even individual stocks if you want more control over taxes.
As always, we are here to help.
