With economizing now a national pastime, some financial experts are astonished at how many of us actually overpay our income taxes. One of the simplest tax-avoidance maneuvers — tax-loss harvesting — is often ignored. “Even after I tell my clients to harvest, they rarely do!” says Adam S. Kazan, CPA, a Philadelphia-based tax advisor.
“Most people simply don’t want to do tax planning, often fearing that it is too complicated. But tax-loss harvesting isn’t very difficult, and some people — especially with most investments beaten down — could truly save a bundle.”
Tax-loss harvesting refers to selling investments you’ve lost money on and asking Uncle Sam to essentially share the pain. Here are five easy steps to make that happen. Be aware, however, that you must act by December 31 to take a deduction for 2009.
Step 1: Peruse your portfolio
Chances are that you lost value on your investments in the past couple of years, but to tax-loss harvest, you must have lost value in a taxable (non tax-deferred) account. IRAs and 401(k) plan losses don’t count. What you’re looking for, in most cases, is either a stock or a stock fund that has fallen in price since you purchased it.
“Since the markets have dropped dramatically, many of your holdings will likely fit the bill,” says Kazan. In investment-speak, the price you paid for a security is known as the “cost basis.” So you are looking for a cost basis greater than today’s market price. If your investment papers do not list cost basis, you’ll need to contact a representative at your brokerage firm or mutual fund.
Step 2: Sell your losers
Selling the securities — after finding the cost basis — is where many people freeze. “It’s often hard for people to sell securities that have lost value. They feel like they are locking in their losses,” says Kazan. That’s true, in a sense, that you would be locking in your losses. But (as you’re about to see in Step 3) losses aren’t always such a bad thing.
Step 3: Seal your nest egg
Simply having sold a loser, you have experienced what’s known in the tax business as a capital loss, and capital losses are generally tax-deductible. So far, so good! Now you have just two main things to be careful of. First, the “wash-rule”: Don’t ask why, but the IRS will disallow any tax deduction if you repurchase the same security within 31 days … so don’t. But being out of the market for a month presents you with a second potential problem: The market will heat up, and you’ll be left out in the cold. The solution is to “seal” your portfolio by buying a similar (but not identical) security. You can then keep your proxy, or, if you prefer, sell it after 31 days and repurchase your “old” security. And here’s where selling your depressed security should not be seen as anything horrible: Your proxy is going to be similarly depressed and poised for a like price pop if the market starts to boil.
Step 4: Garner your profits
Suppose you bought a stock or a stock fund for $10,000 several years ago, and the market value has since swooned
to $6,000. If you sell, you will have a capital loss of $4,000. You can use that $4,000 in one of two ways, explains Will Holt, CPA, with Financial Symmetry, Inc., a financial planning firm in Raleigh, North Carolina. First, you can apply the entire amount to offset any capital gains (gains from selling a security at more than you bought it for).
But even if you have no capital gains this year, you can still deduct up to $3,000 from your regular income when calculating your taxes owed. “That’s a substantial saving for minimal effort,” says Holt. The remaining $1,000 of your capital loss can be written off next year’s (2010) taxes. And if you pay state income taxes, you likely can write off some of those, too. Invest your total savings, and it will grow with compound interest over time. “Your simple tax-loss harvesting, which took you perhaps a few minutes, could wind up adding significantly to your wealth,” says Holt.
Step 5: Fine-tune the process
If you are unfamiliar with tax-loss harvesting, you might want to bring in the assistance of a financial professional, at least until you feel comfortable with the process.
“There aren’t too many potential snags, but there are some,” says Holt. Be careful when buying and selling mutual funds if there’s a load or short-term redemption fee. Be aware of the commissions you pay for trading individual stocks or exchange-traded funds. And finally, know that the IRS rules can be a bit tricky regarding what constitutes a “similar, but not identical,” security. “There’s a bit of a learning curve with tax-loss harvesting, but the potential savings are great enough that it is well worth putting in the effort,” says Holt.
Russel Wild, MBA, is a NAPFA-registered financial adviser who has written nearly two dozen books, including Index Investing for Dummies and Bond Investing for Dummies