RESOURCES
TAX AWARE INVESTING Jimmy Pickert; ACG Portfolio Manager
Most investors are aware that their investments may generate taxes from time to time, whether it is from realizing a capital gain, receiving income from an investment or taking a distribution from a retirement account. Some investors are too tax averse, meaning they will let their desire to avoid a tax consequence be the driving factor in their investment decisions. This is counterproductive— investment related taxes are generally a sign that an investor has made money, and isn’t that the objective? While investors should not let the tax “tail” wag the investment “dog”, there are a number of ways to reduce investment related taxes without hurting one’s overall investment strategy. Reducing tax drag has always been important. The impact of taxes on an investor’s wealth may not be substantial each year, but over the decades of an investor’s career and subsequent retirement, taxes can lead to significant wealth erosion as the tax liabilities compound year after year. This can translate into an opportunity cost in the hundreds of thousands of dollars for many investors, potentially even more for high earners like dentists. With a renewed interest in increasing taxes coming out of Washington, there has never been a better time for investors to add some tax reducing tactics to their investing toolbox.
Tax Loss Harvesting
Tax loss harvesting is one of the most well-known tax tactics for investors. It is the process of selling an investment that carries an unrealized loss. The loss realized by the investor can be used to offset realized gains elsewhere. Additionally, you can deduct $3,000 of realized losses per year from your taxable income. And if you still have realized losses to use after offsetting all your gains
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and $3,000 of your taxable income, you can carry forward those realized losses into future years indefinitely. Where most investors get hung up on this topic is their reluctance to sell and make their loss permanent. This is sound thinking—after all, Investing 101 tells us that we should buy low and sell high, not the other way around, and additionally that we shouldn’t sell out of our investments in the middle of a bear market. You might ask, “Well, what if I sell this stock and just buy it back right away?” Fair question, but the IRS has anticipated that loophole by creating the Wash Sale rule. If you sell an investment at a loss and then buy it back within 30 days, you don’t get to use that loss to reduce your taxes. This creates a dilemma, because no investor wants to see the investment, they just sold rally higher during that 30 day window. The solution to this dilemma is to purchase a similar, though not identical,
investment immediately after the sale of the original. A simple example can be used to demonstrate this process. You currently own shares of Coca Cola stock, and your position in that stock has a loss of $10,000. You can sell your Coca Cola stock and immediately buy Pepsi stock with the proceeds. The result is that you have harvested the $10,000 loss, thus accruing a tax benefit, and have meanwhile stayed invested in the market in case there is a rebound in the soft drink industry over the next 30 days. After 30 days, you can either swap back into Coca Cola or you can stick with your new Pepsi stock. By the way, tax loss harvesting is not limited to individual stocks. Is your diversified mutual fund or exchange traded fund trading at an unrealized loss? You can sell it to harvest that loss and replace your exposure with a similar mutual fund or exchange traded fund. Many investors review their portfolio in December each year to identify opportunities for loss harvesting, but another great time to do this is in
