With the year quickly coming to a close, investors have only a few more weeks with which to impact their tax burden for 2022, suggests Chuck Carlson, dividend reinvestment specialist and editor of DRIP Investor.
Tax harvesting is one way to reduce your investment tax liability, but you have to play by the rules in order to maximize harvesting opportunities.
➤ What is tax harvesting? Investors incur a potential tax liability every time they sell a profitable investment that is held in a taxable account. However, if you have realized profits by selling winners during the course of the year, you can reduce your potential capital-gains tax burden by offsetting those gains with losses.
Look through your portfolio and consider selling stocks or funds on which you have losses. You can offset realized gains with realized losses and take an additional $3,000 in losses against taxable income in the tax year. You can also carry over to future tax years excess losses that you can use to offset future gains.
➤ Follow “wash-sale” rules. If you sell a losing investment in order to offset realized gains, make sure you don’t run afoul of “wash-sale” rules. A wash-sale occurs when an individual sells or trades a security at a loss and, within 30 days before or after this sale, buys the same or “substantially identical” security. Thus, if you plan to sell a stock to book a loss, make sure you don’t buy back the stock within 30 days.
➤ Mutual funds and exchange-traded funds offer some “wiggle room” when tax harvesting. Let’s say you have losses in four large-cap stocks, you want to realize the losses to offset gains, but you don’t want to stay out of the market for 30 days with the cash.
One approach would be to sell the losers and immediately buy a large-cap index fund or exchange-traded fund, such as the SPDR S&P 500 ETF Trust (SPY) exchange-trade fund.
By doing this trade, you will retain market exposure in large-cap stocks without running afoul of the wash-sale rules. If, after 30 days, you decide you want to buy back the individual stocks, you can sell off the ETF and buy back the stocks. Such “tax arbitrage” can also be done in the bond market using bond mutual funds and exchange-traded funds.
Given that this year has seen one of the worst bond markets in history, it is likely investors are sitting with losses in some of their bond funds. If you want to realize those losses to offset gains, yet still keep your exposure to the bond market, you can sell one bond fund and buy a similar but not identical bond fund.
➤ Make sure you know a mutual fund’s potential tax liability. I know most of you own individual stocks, especially DRIPs. However, I’m sure many of you also own funds. Mutual funds usually distribute capital gains late each year, typically in November and December.
When funds sell securities to manage their holdings, cover shareholder redemptions, or rebalance their portfolios, the net gains from the sales are spread among all shareholders, regardless of how long they owned a fund. Thus, even if you purchase fund shares shortly before a distribution, you will owe taxes on a full payout if a fund is held outside a retirement account. Distributions are taxable income, even if you reinvest the money in more shares.
I can tell you firsthand that mutual funds can drop some unpleasant tax bombs on you via capital-gains distributions. Thus, before buying a fund in a taxable account, check its website for details about short- and long-term gains. Most fund companies publish estimates by mid-November, showing the projected amount and payment date.
Importantly, consider waiting to invest until after the payout date, which allows you to purchase shares at a lower price and side-step a distribution. And if you own a fund that is planning to make a capital-gains distribution, you can sell the fund prior to the distribu-tion and buy a replacement fund that is not “substantially identical.”
And if a fund you own has already distributed capital gains, check the amount at the fund’s web site and see if you can tax-harvest before year-end to limit the tax bite.
➤ Finally, consider investment appeal when tax harvesting. I’m not suggesting that investors unload every investment on which they have a loss. True, it doesn’t seem like there is much risk in selling to book a loss and buying back in 31 days.
However, remember that stocks can make big moves in a short period of time. Thus, tax harvesting does expose investors to certain opportunity costs, especially if investors sell just before a big upswing in the market.
The best tax-harvesting candidates are those you know you aren’t likely to buy back or investments that have a similar replacement security so that you can book the loss and still maintain your desired market exposure and asset allocation.