Tax Loss Harvesting

Aside from rebalancing tax loss harvesting is one of the only free lunches available in the investment world. Correctly executing a tax loss harvest will allow an investor to claim capital losses in order to offset their capital gains. At the same time they should be able to maintain there set asset allocation. In effect a tax lost harvest will allow you to pay fewer taxes and thereby enhance your investment returns.

Every time an investor sells an investment, such as when they are rebalancing, they will inadvertently trigger either a capital gain or a capital loss. For instance, when you sell an investment for more than you paid you will realize a capital gain. On the other hand if you sell an investment for less than you paid for it you will realize a capital loss. Capital losses will offset your capital gains and thereby reduce your overall tax bill. In addition up to $3000 in capital losses can be used to reduce your earned income. Any excess capital losses are carried forward and applied next year’s tax bill.

Now that we had a quick run down of the crazy US tax system we can explain how tax loss harvesting works. Let’s assume it’s some time in December and you are getting ready to rebalance your portfolio. During this time you notice that selling one or more of your index funds would result in a large capital loss. In order to tax loss harvest you would sell this index fund and realize a capital loss which will offset any gains. After you have sold the index fund you have one of two options:

The first option is to immediately purchase a similar index fund that has a high correlation to the index you sold. For instance lets assume the index fund you sold tracked the S&P 500. In this case you could purchase the Wilshire 5000 index, the Russell 1000 index, or some other LCB index. The point being is that these indexes will perform very similar to the index you sold and not effect your overall allocation. Please make sure you do not purchase another fund that tracks same index. This could be looked upon negatively by the IRS and nobody wants to draw their attention.

The second option is to wait 31 days and repurchase the same index fund. This will allow you to avoid a wash sale which would essentially nullify your capital loss. No point in tax loss harvesting if you don’t get to claim a tax loss, is there? Some investors fear being out of a section of the market for 31 days. If you fall into this category I suggest using option number one.

Some short comings do exist in regard to tax loss harvesting. The most prominent shortcoming is the fact that you must have a fund that would result in a capital loss if sold. This should not be a factor for newer investors as it is likely that some portion of their portfolio has not performed well. However, after an investor has held index funds for many years it is likely that every fund they hold has capital gains. If this is your case tax loss harvesting is simply not an option.

Overall, tax loss harvesting is a very useful tool. If correctly executed it will enhance an investors returns by helping to eliminate taxes. As every investor strives to increase their returns only those that believe they owe Uncle Sam extra money would fail to tax loss harvest.