Disposing of Your Unproductive Securities for Tax Saving Benefits
Do you remain attach on to that unproductive tech stock or mutual fund that you acquired at the last time the market had a bullish run? Or, perhaps, you possess some emotional connection with a security that long ago ceased bringing any substantial growth from the time you bought it. In that case, considering tax advantage as a yardstick, now could be the best opportunity to get rid of such pet securities. The tax savings you will obtain vis-a-vis your losses can run up to a big amount if you follow all the rules and apply some helpful tips on market.
Tax-loss gathering or harvesting, usually referred to as tax selling, is an approach to use to skirt taxes imposed on some of your portfolio revenues. It simply involves the selling of securities, often during the tail-end of the year, to realize portfolio losses, which an investor can utilize to balance off capital gains and, as a result, reduce individual tax payments.
Tax Treatment of Revenues
Most people who have mutual fund shares are normally given a year-end payout, whether it is in the form of a dividend, interest payout, short-term capital gain or long-term capital gain. If the security paying out is in a taxable account, you may be required by law to pay tax on your revenues.
To satisfy tax-reporting requirements, the difference between the short-term gains and losses (within a year period) are computed the tax year. After that, long-term gains and losses (over more than a year period) are also netted. Lastly, the remaining figures are balanced off. For example, a net short-term loss of $10,000 can be used against a net long-term gain of $5,000 for a remaining short-term loss of $5,000 [-$10,000 + $5000 = -$5000]. For any particular year, no limit is set on the value of capital losses that can offset capital gains. Nevertheless, you may only avail of as much as $3,000 net loss to be deducted from ordinary income; any loss beyond that may be carried forward into your tax payments of the coming years, while keeping its category as either a short- or long-term loss.
The Wash Sale
IRS applies the so-called wash-sale rule to disallow a loss deduction from selling a security if a ‘substantially identical security’ (please see definition below) was bought within a period of 30 days before or after the sale. In actuality, the wash-sale period adds up to 61 days, covering the 30 days prior to the date of sale and then 30 days thereafter. Hence, 100 IBM shares bought on Dec. 1 and afterward sold on Dec. 15 at a loss will not be entitled to any loss deduction. Likewise, those same shares sold on Dec. 15 and then bought back on Jan 10 in the next year is not entitled to a deduction. The whole intention of the wash-sale rule is to disallow investors from trading only for the advantage of escaping taxes.
Substantially Identical Securities
Selling Intel stock and afterward acquiring Microsoft stock will not be taken as trading identical securities, freeing you from the wash-sale rule. On the other hand, buying and selling Microsoft stock is, obviously, dealing in substantially identical securities. Likewise, purchasing ABC Tech Fund and selling ABC Tech Fund involve identical securities.
While selling and buying under the wash-sale period does not entitle you to a loss deduction, the loss can be carried over to the cost of the new shares you will be buying, raising your overall cost in the newly-purchased shares.
It is a gray area when you sell an S&P 500 index fund and then buy an S&P 500 index fund right after from another company, owing to the IRS ambiguity on wash sales and mutual-fund trading. You may not find any problem availing of loss deduction from this kind of deal. Most tax experts, however, advise against this dubious practice.
Take a look at the following tax-beneficial approaches and rules to evaluate when applying tax-loss harvesting into your investment strategy:
- If you decide to remain stay in the asset category, you can buy a comparable but not significantly identical security soon after you sell your original tax-loss asset position. Take for instance this case: If you possess 100 shares of the Vanguard Healthcare Fund and you bought shares in the Putnam Health Sciences Fund, which is not identical to your other fund, you can dispose of your Vanguard shares and realize a loss while keeping your investment in the same industry.
- If you think afterward that selling the security and realizing the capital loss has not changed the security’s viability, let the 31 days of the wash-sale period pass and then buy back the original security.
- Just keep in mind that there is no limitation to the level of capital losses that can be used to offset capital gains. Nevertheless, only a $3,000 loss can be availed of to offset ordinary income tax liabilities in any particular year. As mentioned above, the remaining losses can be carried forward into the coming tax years.
- For spouses filing separate tax returns, the highest allowable capital-loss deduction is $1,500 for each spouse, not $3,000 each. If any one of the spouses dies, the loss may be availed of only on the final tax return of the deceased; the surviving spouse cannot carry over the personal losses of the deceased.
Tax-loss harvesting is a process involving the sale of your losing securities to offset your taxable gains. While it is a beneficial way to minimize your tax payments, make sure to observe the wash-sale rule, which prohibits deductions during the 30 days prior to or after you bought the security. Take ample time to think of how the losses produced by your portfolio can balance out your existing or the coming year-end capital gains. It is one sure way of saving cash as well as of disposing of any lingering, unproductive asset in your portfolio.