The idea that you can win by losing doesn’t make a whole lot of sense. In fact, most of you may consider this statement not only false, but a bit irrational to boot! Yet for those of us who are investing in a taxable account, the Federal Government, as well as most State and Local Governments will share in any capital losses you may experience from your activities in the securities markets. A tax-wise investor will use a technique known as tax loss harvesting to share those losses with the Government.
Tax-loss harvesting is when you purposely sell a security that you own at a loss, so as to realize and utilize that loss on your income tax return. Most of the time, this strategy is taken to offset a gain during the same tax year, but there are reasons to create excess losses to be used to offset future income. The harvested “loss” is valuable in that you offset any gains taken and pay taxes if, and only if, your gains are greater than your losses. Even then, if you have more losses than gains, you can apply up to $3,000 of the excess loss against your ordinary income. If your net losses exceed $3,000 in any given year, you can use the left-over against future capital gains and ordinary income, until all your losses are netted or written off.
In 2001 Robert “Rob” Arnott, Andrew Berkin and Jia Ye of First Quadrant published a report titled “Loss Harvesting: What’s It Worth To The Taxable Investor?” Rob Arnott has garnered recognition and respect through his work on fundamental index investing. The authors quantify the value of tax loss harvesting in this statement:
“We have simulated returns for 500 assets over 25 years to examine the benefits of loss harvesting for taxable portfolios, and found a huge advantage over the passive case. By rigorously realizing losses, the median portfolio would add about 27% compared to a pure buy and hold strategy in typical market conditions. Even after liquidation, net of all deferred taxes, this advantage is still an impressive 14%.”
In today’s world of anemic interest rates and less than stellar returns from your common stock portfolio, the opportunity to earn a reliable and somewhat predictable excess ½% to 1% rate of return should not be passed up. For example, on a $500,000 portfolio, Arnott and crew estimate potential excess earnings of $135,000 over 25 years. Call me silly, but I consider that “real” money.
As with any tax advantaged investment program there are reasons to be cautious. There are special IRS provisions that could disallow a deduction which you should know prior to implementing any tax-loss harvesting. The most common is the wash-sale rule, selling at a loss, and then repurchasing the same or similar investment within 30 day. Getting help from a professional is worth the effort.
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