A Proven Strategy to Keep the Tax Man at Bay
October has a reputation as a historically volatile month in the stock market and this year was no different. The S&P 500 lost nearly $2 trillion of value last month, its worst showing since September 2011.
But there’s one month that scares me even more, and that’s December. It’s not that December is a bad month overall. But it can be bad for patient, long-term investors.
Markets can be volatile and unpredictable over the short term, so my philosophy is to invest in companies that should benefit from long-term trends. But even promising holdings may be in negative territory for the year, in which case they may have additional punishment awaiting in December.
Many investors, including myself, will utilize tax-loss harvesting near the end of the year. This strategy can be used to offset gains in your portfolio.
For example, if you have a capital gain this year on Apple (NSDQ: AAPL) — which I actually do — you can offset some or even all of that gain by selling a holding that is in the red. This is called tax-loss harvesting and it can reduce your overall tax bill.
What that means is that companies that are down for the year may experience extra selling pressure in December. Companies that are in positive territory may not experience the same kind of selling pressure, because most people aren’t anxious to lock in taxable gains at year-end.
This is the time of year that you should start to look over your portfolio and make those kinds of strategic decisions. You can even considering selling a company that you still like, but be careful about the “wash sale” rule in the tax code. This rule prohibits a taxpayer from claiming a loss on the sale of a security and then buying a “substantially identical” security within 30 days of the sale.
What does “substantially identical” mean? It obviously covers selling and buying back common shares in the same company within 30 days. Beyond that there is a lot of room for interpretation in the rule. For instance, an S&P 500 index fund run by one company may be deemed by the IRS to be “substantially identical” to an S&P 500 index fund run by another company.
So, I can’t sell shares of ExxonMobil (NYSE: XOM), claim a loss on the sale, and then buy shares of ExxonMobil back within 30 days. But I could replace my ExxonMobil with shares of Chevron (NYSE: CVX). That would be a way to lock in losses for tax purposes, while maintaining the same sector exposure.
I would certainly rather be looking at gains across my portfolio, instead of locking in losses to offset gains. But investors have to use every tool at their disposal to maximize returns. In this case that may mean taking a loss to minimize the check I have to write to Uncle Sam.
But you may not want to wait until December to do it, because that’s when lots of other investors will be employing the same strategy.
Looking for other profitable strategies? Look no further than my colleague Jim Fink, chief investment strategist of Options for Income.
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