With the Christmas season in full effect, financial advisors, money managers and stock traders alike are checking their list and checking it twice, for potential tax-loss harvesting opportunities in their clients’ portfolios. Tax-loss harvesting is the process of selling one investment at a gain, and selling another at a loss, in hopes that the combined transaction would either completely, or partially offset the tax consequences associated with the securities individually. The tax-loss harvesting strategy is only effective in non-qualified accounts, such as individual brokerage accounts, joint accounts, trusts and transfer-on-death accounts, since the taxes on those accounts are not deferred, but are applied in the tax year in which they are realized.
One main consideration when selling stocks for tax-loss harvesting purposes is to ensure that the overall asset allocation and long-term strategic goals of the account are not disrupted. Maintaining proper asset allocation, while at the same time being tax sensitive, can be accomplished by simultaneously replacing the security that was sold with a similar security. However, when identifying investments as simultaneous replacements for investments that were recently sold, investors must be cognizant of the Internal Revenue Service’s (IRS) “wash-sale” rule. The IRS defines a “wash-sale” as the process of purchasing a “substantially identical” security within 30 days before or after the sale of another security. When a “wash-sale” occurs, the loss is not recognized by the IRS and therefore, cannot be claimed on the investor’s tax filing for the year. However, while the IRS is not clear on exactly what “substantially identical” means, they do make it clear that selling a mutual fund and replacing it with an exchange-traded fund (ETF) for example, is not considered a “wash-sale”. It is also important to note that regardless of how similar a particular security may be to another, it will still likely have some significant differences and should be utilized as a suitable replacement only after carefully considering an investment’s objectives, the client’s cost basis, their investment time horizon, as well as their risk tolerance.
In closing, a tax-loss harvesting strategy can often offer an investor a sizeable tax advantage, while in other situations, can potentially cause capital gains to be realized without any offsetting lose if a transaction is considered a “wash-sale”. In either case, it is important to first discuss your tax situation with your tax advisor, as the advisors at America’s Retirement Headquarters and the Retirement Guys Formula, LLC do not provide tax or legal advice. This article is for illustrative purposes only and should not be used for the purpose of avoiding taxes or penalties.
Have a safe and Merry Christmas!