Strategy
Reduce the Sting of an Investment Loss
By Wayne Michael Lottinville, CFA
Chief Investment Officer, Cascadia Investment Consultants
Many people find it hard to sell losing investments.
This deep-rooted reluctance even has a name, the
“disposition effect.” The disposition effect appears
to trouble everyone, according to a recent article in
Barron’s, an investor newsweekly. Academic
researchers have turned it up in Finland, Israel,
Australia, and China. If the loser isn’t sold, one
rationalization goes, the loss is just “on paper” and
somehow isn’t “real.” Sooner or later the investment
will rebound—don’t they all? Then it may be sold—
what a relief!—at a gain, and the investor’s fragile
ego remains intact.
But this short-sighted view overlooks potential tax
benefits. True, without taxes, the merits of each
investment are correctly based on its future
prospects and its potential for diversifying a welldrawn
investment plan. Past losses are essentially
“sunk costs” and should have no bearing on the
decision to retain or sell the investment. In taxdeferred
accounts [IRAs, 401(k)s, etc.] for example,
it might make sense to hold on to a loser because its
future prospects and diversification potential are
favorable.
Not so in a taxable account, where the “disposition
effect” wreaks its worst havoc. This is because in a
taxable account [again, not in IRA, 401(k), or similar
tax-deferred accounts], investment losses can be
used to significantly reduce the investor’s tax bill. By
not selling losers, the investor may preserve his
fragile ego, but he is foregoing potentially significant
tax savings. He adds insult to injury.
Get Over It!
This is what reluctant sellers must do: Get over it!
I’m not advocating that we go out and look for
losing investments. Gains are certainly better, even if
we have to pay a stiff tax on those gains. But the
reality is that even the most admired and successful
Wall Street whizzes buy many losers. No one bats a
thousand. Success is achieved by creating and
following an appropriate investment plan. With a
good plan, winners are more likely to outpace losers,
and investment goals are more likely to be met.
A good plan also accounts for the effect of taxes on
investment returns. The reduction in taxes created
through judicious tax-loss selling may be viewed as
excess investment returns. After all, this reduction in
taxes puts more money directly into the investor’s
pocket, just as outsized investment gains do. The
reduction in taxes can easily amount to hundreds or
even thousands of dollars. The most successful
investors use every reasonable advantage to increase
their wealth, including harvesting capital losses to
offset their capital gains and reduce their taxes.
Harvesting Guidelines
The amount of tax reduction you might achieve will
depend on your particular tax situation. Consult your
personal tax advisor or investment manager for the
details. But to help you get started, here are a few
general guidelines that should work in nearly every
situation.
Harvest your losses all year long, not just at yearend.
Many investors conduct year-end reviews with their
tax advisors, which is a good thing. If earlier in the
year they sold an investment at a gain, their tax
advisors might suggest selling something else at a
loss to offset that gain. This is great advice, but why
wait until yearend? Savvy investors harvest losses
throughout the year whenever they can.
With enough losses, you may be able to reduce the
taxes on gains to zero. If you have no gains to offset,
harvest your losses anyway. There are two very good
reasons for this. First, even if you have no capital
gains to offset, you can still offset $3,000 of your
regular income. If you are in the 35 percent tax
bracket, for example, that’s a potential reduction in
your tax bill of $1,050 (refer to the nearby table). If
you are only in the 10 percent tax bracket, you still
might be able to cut your tax bill by $300. Your state
income tax bill should be lower too.
Second, you can put your losses in the “bank” and
use them in the future. Any losses you don’t use this
year can be carried forward indefinitely (at least,
according to current tax law). At some point, you
will want to sell some of your winners to fund your
retirement, buy real estate, pay tuition bills, or
whatever. Any unused losses may offset capital gains
from selling your winners, plus reduce your taxable
income by $3,000.
For example, you have $20,000 in capital losses and
$10,000 in capital gains. You can use $10,000 of
your losses to offset your gains, $3,000 to offset
other taxable income, and put the remaining $7,000
in the “bank” to offset future gains or income. Make
it a goal to reduce your taxable income by $3,000
every year through judicious tax-loss selling and
“banking.”
One caveat: Watch transaction costs. If transaction
costs outweigh the tax benefits, then it may not
make sense to sell a loser. On the other hand, if the
impact of transaction costs is
significant, perhaps it’s not
the best investment anyway.
Mind the Tax Man
Almost always, you can
sensibly harvest a loss even if
that particular investment still
makes sense in your portfolio.
This is possible because you
can usually replace your loser
with something nearly identical, but still different
enough to satisfy the tricky rules of the tax man.
According to IRS rules, if you sell a loser and then
you buy “substantially identical stock or securities”
within 30 days after (or before) the sale, your loss
will be disallowed. Whoops! There goes your tax
deduction.
To get around this, sell the loser and buy something
similar, but not “substantially identical”—a term
narrowly interpreted by the IRS. It’s okay to sell
Ford and buy GM, for example, or to sell the
Vanguard 500 Index fund and buy the Vanguard
Total Stock Market Index fund or Vanguard Large
Cap Index fund, or to sell a Georgia July 2011 AA
municipal bond yielding 3.351 percent and buy an
Indiana July 2011 AA muni yielding 3.355 percent.
Beware, if you sell Ford at a loss and your spouse
buys it within 30 days, the loss is disallowed.
Transactions with controlled entities or related
parties may also be disallowed. If you sell Ford at a
loss in a taxable account and buy it in a retirement
account within 30 days, it’s probably a technical
violation of the rules, although some tax experts
claim it’s okay. I would avoid it, however.
Finally, if you make a mistake, the IRS will not
penalize you, but you will lose the current benefit of
the tax loss and will need to rethink your plan.
Click here to submit request>
Go Back to Topic Page>
If you are an advisor and would like to see your articles published, click here
Article reprinted by permission. Unauthorized reproduction of content prohibited.
|
