At Soundmark, we have always stressed the importance of low-cost, tax-efficient investing. As many of you know, we accomplish this strategy by:
- Using low-cost index or passive asset class mutual funds and exchange-traded funds (ETFs). These types of funds generally have less turnover (i.e. sales of stocks they own which create gains) than active mutual funds and are therefore more tax efficient.
- Incorporating tax-managed mutual funds into our clients’ taxable accounts. We will also incorporate ETFs into our clients’ portfolios, which can provide them with even greater tax efficiency.
- We leverage asset “location.” We place the more tax-efficient funds in our clients’ taxable accounts and place the less tax-efficient funds, such as bonds, in their tax-deferred accounts (such as IRAs and 401(k) plans).
During a down market like we’re experiencing now, there is another powerful strategy we can use to improve our clients’ tax efficiency. It’s called “tax-loss harvesting,” which involves selling a fund at a loss and immediately investing that money in a similar (but not identical) fund. This strategy allows you to realize a loss that can be used against future capital gains (or capital gain dividends) and allows you to stay invested in a similar stock position.
Here is how loss harvesting works:
Let’s say you have a portfolio that creates approximately $10,000 in capital gain distributions (i.e. gains from the sale of stocks within a mutual fund). Let’s say you also own a $100,000 stock mutual fund investment that’s showing a $20,000 loss. By selling the $100,000 mutual fund, you would realize a $20,000 loss. You immediately invest the proceeds from that sale into a similar, but not “substantially identical” position. That way, you maintain the same allocation you had before the sale.
Your $20,000 loss can then be used against your capital gains distributions for that tax year. At the current 15-percent tax rate for long-term capital gains, this move would save you approximately $1,500 in taxes. If you have no further capital gains for the year, you can take an additional $3,000 loss at your ordinary income tax rate. Assuming you’re in the 25-percent tax bracket, you would get an additional tax savings of $750, for a combined tax savings of $2,250 for the year ($1,500 + $750). Even better, any of your unused losses – in this case $7,000, can be carried forward to the next year and used in the same manner.
Beware the Wash-Sale Rule
VERY IMPORTANT: The key to this transaction is to avoid the “wash-sale rule” which states you cannot realize a capital loss for tax purposes if you invest in a “substantially identical” stock or security 30 days before (or after) the sale of the security at a loss.
Each client’s tax situation is unique. Your tax savings will vary depending upon your income, capital gains, and deductions. At the high end, the maximum capital gains tax rate can be 23.8 percent with an ordinary income tax rate of 37 percent.
Stock market volatility is highly distressing for most people. But ultimately, we believe that short term volatility is always offset by reasonable long-term returns. With tax-loss harvesting, you can take advantage of today’s short-term negativity and turn it into an opportunity.
As I wrote two years ago this month – Taxes – the Silent Killer in Portfolios, most investors don’t recognize the impact that taxes have on their portfolio performance because their tax hit is not reflected in the returns they see on their portfolio statements. Being cognizant of this fact is one of the many ways we help our clients maximize the after-tax investment returns.
I know these are unsettling times. Contact me at any time if you have concerns about your asset allocation or retirement readiness.
Todd Flynn, CPA, CFP® is a principal at Soundmark Wealth Management, LLC. Todd works closely with physicians, business owners, and other successful and accomplished individuals to help them define their financial goals and implement an ongoing financial planning process.