Reduce the Sting of an Investment Loss

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.