The only things guaranteed in life are death and taxes. Well we spent all last month discussing life insurance, so now we’re on to taxes! And while you don’t have to be a tax pro, you should keep up a general understanding so you can be sure the professionals you’ve hired are using all tools in the metaphorical box to make the most of your financial life.
We recently entered the fourth quarter of 2019 which is when we begin planning for year-end tax decisions and one of these decisions is tax loss harvesting. The gist of tax loss harvesting is realizing investment losses to offset investment gains or earned income. While that seems fairly straightforward, is anything really ever straightforward when it comes to the government and its tax laws?
What goes into Tax Loss Harvesting?
First off, let’s clarify that realizing investment losses means you actually sell the investment at a loss, not just that your investment is valued lower than when you purchased it. For example, if you bought an investment for $10,000 and it’s now worth $9,000, you haven’t realized the $1,000 loss until you sell that investment at $9,000. Of course, in lieu of selling, you could hold the investment in the hopes it would rebound and eventually be worth more than when you purchased it.
That’s where proper tax loss harvesting comes in – weighing the tax benefit of selling at a loss versus analyzing the investment potential. It’s just the nature of investing that we can’t win ‘em all. But in a given tax year, you’re only able to claim $3,000 of realized losses so determining which to sell (and thus realize) should be analyzed. Because of the details of the tax law, it’s an increasingly complex process to decide which investments you should hold, which you should realize losses, etc.
In addition to determining which losses to realize, it’s important to evaluate what gains/income you’re going to offset with the loss. See, short-term (investments you’ve held for less than 12 months) capital gains are taxed at your ordinary income tax rate. This means if you’re a high-income investor, your short-term gains could end up having huge tax implications. Long-term (investments you’ve held for 12 months or longer) capital gains are taxed only high as 20%, so if you’re a high-income earner, your tax obligation is less (all things equal) on long-term gains than short-term gains.
Another potentially complicating aspect for determining gains and losses is that some investments, mutual funds in particular, pay out dividends in the fourth quarter that will impact the amount of gain or loss on the investment. However, funds legally have until December 31st to officially distribute those dividends. Ever spent a New Year’s Eve day calculating capital gains and losses so to get any trades in by market close? It’s not fun. Admittedly, with the advances in technology, it has been easier for fund companies to distribute their dividend estimates earlier and earlier in the fourth quarter, but they remain only estimates.
Yet another thing to consider (isn’t it exhausting considering all these things?!) for taxes is another IRS rule named the Wash Sale Rule. In short, it’s a rule to eliminate people selling positions solely for tax purposes. Under the rule, if you realize a loss and use it as a deduction, you cannot buy back the same investment in the 30 days after the sale. But, not only are you forbidden from buying back the same investment, you’re prohibited from buying back a ‘substantially identical’ investment. I told you there were a bunch of caveats!
Does Tax Loss Harvesting Only Effect Taxes?
Lastly, not only should taxes be given a fair amount of analysis, but your overall financial plan should be considered as well. It’s too easy to look in one-year time periods for tax-time decision making and forget to consider the 10-, 20- and 30-year implications those decisions. Saving some money this year on taxes could have far reaching and/or magnified implications down the road. That’s why having a team of licensed professionals in your corner can reap tremendous rewards on your financial life.
A CPA (who may or may not be your tax preparer), an attorney, and a financial advisor/planner (who may or may not be your investment manager) all working together to optimize and maximize your financial life will end up paying for themselves over the long run. With so many rules, regulations and the amount of time it requires to keep up with it all, your time (and sanity) are worth the cost of a set of professionals on your side.
If you’re trying to establish or expand upon your own team of professionals for your financial life, feel free to reach out to us at any time! Not only do we do financial planning and investment management, but we have a circle of other professionals we highly recommend that would make a great addition to any team you’re putting together.