In New England as the days get shorter and the temperatures drop families with young children will often visit one of their local farms and pick their own pumpkins for Halloween.
Just writing this brings back great memories of my children when they were young, but there also a different type of harvest that those of us near or in retirement should take part in – definitely not as fun but maybe of lasting value.
What I am referring to is tax loss harvesting. Uh, ah I just filed my taxes for last year and now you want me to focus on the dreaded “t” word again? Please allow me to explain. In my life travels I have never met anybody that does not think that they are paying too much in taxes and would love to lower their annual contribution to the government coffers (in a legal way of course).
One way of doing this which is pretty straightforward but often ignored is tax loss harvesting. Along with enjoying harvesting pumpkins with your children or grandchildren why not harvest your investment losses as well?
After all as we have shown in earlier writings (Leaving Money On The Table) proper tax management of investment portfolios can dramatically alter financial outcomes especially over long periods of time.
How does tax loss harvesting work? Tax loss harvesting is an approach to minimizing how much you pay to the government on the (hopefully) gains in your investment portfolio. What it involves is selling those investments where things did not pan out as expected and you incurred losses. You would then offset these losses with the gains that you hopefully have on other investments. A good background read on tax loss harvesting prepared by Fidelity Investments can be found here.
While everybody’s circumstances are different let us look at a simple example. Let’s say that at the beginning of the year the Mitchell’s bought a portfolio of Health Care stocks that unfortunately lost 20% of its value resulting in a loss of $10,000. They also luckily bought some energy stocks In January that currently exhibits $15,000 worth of gains.
The Mitchell’s are now worried about all the negative publicity surrounding oil surpluses and wish to sell their energy holdings. Doing so would trigger short-term capital gains on which they would have to pay taxes. On the other hand the Mitchell’s think that Health Care stocks will soon rebound after the US Presidential Elections turning their current paper losses into winnings.
But just like things do not always work out as expected, tax issues are never straight forward so in order to lower their overall tax bill they would have to sell both their health care and energy investments. Not really what they wanted to do, but a lower tax bill this year would come in handy to pay for that winter getaway vacation to Costa Rica.
However, what the Mitchell’s can do is go ahead with both sales, legally offset gains with losses and then buy an essentially “similar” investment in health care stocks. For example if they previously owned a basket of Pfizer, Mylan and Bristol Myers stock which they must now sell they could buy the S&P 500 Health Care Exchange Traded Fund (ticker XLV) as a replacement. From an IRS perspective that is a permissible transaction. So essentially they have maintained the same exposure to health care stocks but lowered their tax bill.
Assuming that the Mitchell’s are in the 25% marginal tax bracket they would owe $1,250 to the tax authorities using tax loss harvesting as opposed to owing $3,750 if they had sold their energy holdings and held on to the losing position in health care stocks. And their portfolio is still essentially positioned as they want with a bet that health care stocks will rebound post-election. They just turned lemons into lemonade and are able to save $2,500 in taxes which they can use to travel to their favorite winter spot on Tamarindo Beach in Costa Rica!
Effective tax management requires an integrated approach to portfolio construction and trading that recognizes the potential returns, risks and tax implications of a strategy
Simply reducing turnover or matching winning with losing positions once a year yields some gains but leaves a significant part of the potential tax alpha on the table.
Tax aware optimization techniques while complicated on the surface are commercially available but require customization to account for individual circumstances. In many instances such programs create voluntary losses to offset current investment gains and the more advanced applications encompass security positions across different asset classes.
Eric J. Weigel
Managing Partner, Global Focus Capital LLC
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