The pros and cons of annual tax losses

Many investors collect tax losses at the end of each tax year. This strategy involves the sale of stocks, mutual funds, exchange-traded funds (ETFs) and other loss-making investments to offset the realized gains from other investments. It can bring great tax benefits.

But for many reasons, tax losses may or may not be the best strategy for all investors.

Latest tax rate

The Internal Revenue Service (IRS), many states and some cities assess the taxation of individuals and businesses. Sometimes, the tax rate—calculating the percentage of tax payable—changes. Knowing the latest interest rates on investments can help you determine whether the tax loss gains are now wise for you.

Key points

  • It is necessary to know the latest investment rates to decide whether tax collection is a wise choice.
  • Rebalancing your investment portfolio to complete the tax loss harvest is the best option.
  • One consideration in a given year is the nature of your gains and losses.

For the 2020 tax year, the federal tax rates for projects that may be related to logging include: the highest tax rate for long-term capital gains, 20%; the medical insurance surcharge for high-income investors, 3.8%; and the highest marginal interest rate for ordinary income, 37%.

Although all investors may deduct a portion of their investment losses, these rates make investment losses more valuable to high-income investors.

Understand the wash sale rules

The IRS follows the wash sale rule, which stipulates that if you sell an investment to confirm and deduct the loss for tax purposes, you cannot repurchase the same asset or another item that is “essentially the same” within 30 days Investment assets.

For individual stocks and other holdings, this rule is clear. For example, if you have a loss in Exxon Mobil Corp. and want to realize the loss, you must wait 30 days before repurchasing the stock. (This rule can actually be extended to 61 days: you need to wait at least 30 days from the initial purchase date to sell and realize a loss, and then you need to wait at least 31 days to repurchase the same asset.)

Let’s take a look at mutual funds. If you realize that the Vanguard 500 Index Fund is losing money, you cannot immediately buy an SPDR S&P 500 ETF that invests in the same index. You may be able to buy the Vanguard Total Stock Market Index, which tracks different indexes.

Many investors use index funds and ETFs as well as industry funds to replace sold stocks and do not violate the wash sale rules. This method may be effective, but it may also be counterproductive for a number of reasons: for example, the short-term returns of the purchased alternative securities are very high, or if the stocks or funds sold before you have the opportunity to repurchase greatly appreciate.

In addition, you cannot avoid the wash-and-sell rules by repurchasing assets sold in another account you hold (such as an individual retirement account (IRA)).

Portfolio rebalancing

One of the best options for tax loss gains is whether you can rebalance your investment portfolio. Rebalancing helps to re-adjust your asset allocation to balance returns and risks. When you rebalance, look at the holdings you bought and sold, and pay attention to the cost basis (the adjusted original purchase value). The cost basis will determine the capital gain or loss of each asset.

This approach will prevent you from selling just to realize tax losses that may or may not be suitable for your investment strategy.

A bigger tax bill is coming soon?

Some argue that continued tax loss harvesting in order to repurchase sold assets after the wash-out waiting period will ultimately lower your overall cost base and lead to greater capital gains in the future. If the investment grows over time and your capital gains become larger, or if you are wrong about what will happen to the capital gains tax rate in the future, this is most likely correct.

However, current tax savings may be sufficient to offset higher capital gains in the future. Consider the concept of present value, which means that the one dollar tax saved today is more valuable than the additional tax you have to pay later.

This depends on many factors, including inflation and future tax rates.

Capital gains are not born equal

Short-term capital gains are realized from investments that you hold for a year or less. The proceeds of these short holdings are taxed at the marginal tax rate of ordinary income. The Tax Cuts and Employment Act sets seven tax rates for 2020, ranging from 10% to 37%, depending on the income and how you declare.

Long-term capital gains are profits from investments you hold for more than a year, and their tax rates are much lower. For many investors, the interest rate on these returns is about 15% (the minimum interest rate is zero and the maximum interest rate is 20%, with few exceptions).For the highest income group, an additional 3.8% medical insurance surcharge comes into play.

You should first use the first gain of the same type (for example, long-term gains against long-term losses) to offset the losses of a given type of holding. If there are not enough long-term gains to offset all the long-term losses, the balance of the long-term losses can be used to offset the short-term gains, and vice versa.

Maybe you have had a bad year, but you still have losses that cannot offset your gains. Residual investment losses of up to $3,000 can be deducted from other income in a given tax year, and the remainder is carried forward to subsequent years.

For a variety of reasons, tax losses may or may not be the best strategy for all investors.

Of course, one of the considerations in determining the tax loss harvest in a particular year is the nature of your gains and losses. You need to analyze this or talk to your tax accountant.

Mutual fund allocation

As the stock market has risen in the past few years, many mutual funds have given up large allocations, some of which are in the form of long-term and short-term capital gains. These distributions should also take into account your equation about the tax loss harvest.

Bottom line

For tax reasons alone, selling an investment, even if it is a loss-making investment, is usually a bad decision. Nevertheless, tax relief can be a useful part of your overall financial planning and investment strategy, and should be a strategy to achieve your financial goals. If you have any questions, please consult a financial advisor or tax professional.


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