Time for Tax-Loss Harvesting
Every year, typically in early November, I devote an article to year-end tax-loss harvesting. I do this to remind investors to start thinking about taxes with enough time left in the year that they can develop a plan and execute it.
Taking Some Profits
As in 2021, this year’s big sector winner is energy. Most energy companies have scored huge gains year-to-date. Although the energy sector still looks poised to outperform for the foreseeable future, things can turn quickly. Therefore, it may be a prudent idea to take some profits on your energy holdings. The downside of this is that if you hold such companies outside of a retirement account, you will generate a tax liability.
A short-term capital gain occurs if you held an asset for less for one year before selling it. Short-term capital gains are subject to taxation as ordinary income.
For assets held longer than one year, you will benefit from a more attractive long-term capital gains tax rate. The long-term capital gains tax rates are 0%, 15%, or 20% depending on your taxable income.
Accordingly, one consideration as we head into the end of the year is how long you have held a security. By paying attention to the timing of your sale, you can save yourself quite a lot on your tax bill.
But you can save even more on your tax bill by offsetting those gains with any losses in your portfolio. This is the time of year that you should start to look over your portfolio and make those kinds of strategic decisions.
If you have a diversified portfolio, most companies in your portfolio are probably down. The technology sector was hit particularly hard this year, with even major blue chip technology companies like Intel (NSDQ: INTC) down 50% year-to-date.
But, you can take advantage of a company like Intel that is in the red to offset those that are in the black. This strategy is called tax-loss harvesting and it can lower your taxable gains.
But it also means that companies that are down for the year can face increased selling pressure in December. That’s why I prefer to do my tax-loss harvesting in November.
If you sell off your losers and harvest those losses, you can offset dollar-for-dollar your gains. This strategy is especially appealing to limit the impact of short-term capital gains.
You can even sell a losing 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. However, 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.
I can’t sell shares of Intel, claim a loss on the sale, and then buy back shares of Intel within 30 days. But I could replace my Intel with shares of competitor Advanced Micro Devices (NSDQ: AMD), which is itself down 60% for the year. That would be a way to lock in losses for tax purposes, while maintaining the same sector exposure. The technology sector has been one of the biggest laggards in the S&P 500 this year, but it will bounce back. If you do sell a loser from your portfolio, I recommend you maintain the sector exposure unless you need to rebalance.
I would certainly rather see gains across my portfolio, instead of locking in losses to offset gains. But investors must 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.
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