There is death, there are taxes, and there's death from taxes on gains from investments. This metaphorical fatality comes not from a single pass of the grim tax reaper's sword, but from a thousand cuts. Yet there are ways to heal some of the wounds inflicted by the marauding swordsmen of the IRS. Some of these methods, such as holding retirement assets in tax-deferred accounts, are obvious to even the most casual individual investor.
There is death, there are taxes, and there’s death from taxes on gains from investments. This metaphorical fatality comes not from a single pass of the grim tax reaper’s sword, but from a thousand cuts.
Yet there are ways to heal some of the wounds inflicted by the marauding swordsmen of the IRS. Some of these methods, such as holding retirement assets in tax-deferred accounts, are obvious to even the most casual individual investor.
Less obvious are ways to avoid or reduce taxes by managing investments adroitly. Crucial to this is “harvesting” losses, as professional investors are wont to call the practice, by taking deductions on them to offset taxes on stocks that render gains.
Harvesting losses isn’t refinement of investment strategy. Rather, it’s a fundamental precept. The best professional long-term investors eat, sleep, and breathe tax-efficient investing, and harvesting losses is an essential part of this mentality.
Tax efficiency is all the more crucial these days as investors register hurtful market losses. Why not lessen the pain by strategically channeling these losses into tax deductions? Harvesting losses doesn’t require an MBA in finance. It can be done effectively and efficiently with a few simple rules in mind.
Hold riskier stocks outside tax-deferred accounts. Riskier stocks often include growth stocks which, while potentially beneficial, necessarily involve higher volatility and, therefore, higher risk. Instead of loading up tax-deferred accounts with growth stocks, experts say, investors should fill them with less volatile stocks because these tend to pay taxable dividends more regularly. This way, investors can avoid the dreaded ordinary income taxes on these dividends that are so injurious to high-net-worth investors such as physicians.
Harboring riskier growth stocks in tax-deferred instruments such as IRAs, simplified employee pensions (SEPs), and Keoughs “prevents investors from taking tax deductions on losses from these stocks,” says Scott Leonard of Leonard Wealth Management. Identifying these stocks as potential candidates for harvesting losses and keeping them outside unsuitable accounts, say Leonard and other experts, is essential to boosting net returns.
Take short-term losses by selling throughout the year. To harvest a loss, there must actually be a loss. Too often, experts say, investors plan to deduct a stock loss at year’s end, only by that time, the stock has rebounded and there’s no longer a loss. Then, the next year, the stock drifts downward again.
Investors should evaluate these undesirable stocks throughout the year when they’re down and consider selling then instead of waiting until tax time.
The moral of this tale of doleful volatility is that investors planning to dump such stocks eventually might consider doing so throughout the year to create deductible losses to offset high taxes on gains from other stocks. “A lot of people aren’t conscious of this, and it’s a good technique to keep in mind,” says Joseph Pappo of Lotsoff Capital Management.
Another thing to keep in mind is the original cost of the actual stock being sold. Investors can reap the maximum tax-loss harvest by selling higher-priced shares of a given stock. For a long-term, buy-and-hold investor, this usually means selling the shares of a company purchased last rather than those bought years earlier.
Sell “expensive” shares first. Suppose an investor purchased several blocks of a hypothetical company, JP Widgetcorp, at several intervals over a 4-year period during which the price was consistently ascending. Then came a global widget glut that caused the company’s share price to plummet. This stock is naturally fodder for tax harvesting. But which shares? Which block or portion thereof? Purchased at what price?
These questions are crucial to qualifying for the maximum tax deduction. What determines the amount of loss is the price (or basis) of the particular shares being sold. If investors don’t specify otherwise, the general rule of trading that applies is what’s known as first-in, first-out (FIFO)—that is, absent instructions to the contrary, the first shares purchased are the first ones sold.
So if the investor merely says, “Sell 100 shares of JP Widgetcorp, the broker reflexively sells the first 100 shares purchased when the investor started buying the company 4 years earlier. So, though the investor may own 400 shares of the company, the price of the first 100 shares purchased becomes the (cost) basis in the stock sold and basis for determining the amount of the loss.
Because the price of JP Widgetcorp had been steadily ascending over the period of the purchases, selling the shares purchased early on won’t result in as big a tax deduction as those purchased subsequently. One way to override this default mode is to specify precisely which shares to sell. This is more difficult than it sounds because it involves burdensome monitoring and record-keeping challenges and creates the potential headaches at tax time.
A standing letter to brokers. Mark Fichtenbaum of Twenty-First Securities recommends a simpler solution: All investors need do, he says, is to sign a letter to their brokers setting down a standing order that when they sell a portion of the total shares in a given company, those to be sold are those with the highest basis. Thus, the FIFO rule will no longer apply. “A lot of people don’t have standing orders with their brokers,” says Fichtenbaum. “But it’s a really quick and easy thing to do that can make a substantial difference in the amounts of tax deductions.”
Maximizing tax losses isn’t rocket science, but many financial advisors nevertheless fail to manage this area vigilantly for their clients. This failure may be linked to an overly rosy view of their own skills, as they optimistically tend to think their clients’ assets will do so well under their stewardship that there will be few, if any, losses to deduct.
Given the market’s performance in recent months, this mentality may be changing. Regardless, individual investors can take action on their own to harvest existing losses and plan to do so in the future.
Richard Bierck is a freelance financial writer and editor.