Tax loss harvesting, why you should do it before year end.
November 01, 2008

A new study by Lipper, a Reuters company, shows that investors needlessly give up as much as 23% of returns to taxes.”

Beverly Goodman, 8/26/02

So you have endured the pain of the market decline. Now is the time to position yourself to take advantage of every opportunity to bring your portfolio back to its previous value. Managing your after tax returns is a significant part of the process.

Tax loss harvesting has not only gotten easier, it is more efficient and low cost to implement. And there is no limit to the dollar amount of capital losses that can be used to offset capital gains earned during the year. Take your federal tax rate, 35% is the top, and add in another 3% if you are an Illinois resident. If you can take a 38% savings on your earnings, isn’t it worth looking into? In addition, if you have the losses, you can take another $3,000 deduction from ordinary income. This $3,000 deduction from income alone can put an additional $1,200 in your pocket. And remember, you can carry unused losses forward and apply them against future income and gains.

The process is simple; look at your portfolio for any short or long term losses; including mutual funds, ETF’s, and individual securities. Before you sell these securities or funds, decide whether these are investments that you want to retain as part of your overall portfolio. If they are investments worthy of keeping, then you will need to sell them and keep them out of your portfolio for 30 days (often referred to as the “wash sale” rule) before you can buy them back. In this tumultuous and unpredictable market, you may not want to part with that security for 30 days, so when you sell, you’ll need to find a short term viable substitute. Do factor in transaction costs when making this decision. Funds can impose a redemption fee if you sell within a short period of time from purchasing. Most custodians such as Fidelity or Schwab will charge a small transaction fee of just $8-$10.00 per trade.

This is where ETF’s can be an easy, efficient and low cost alternative. Replacing a portfolio for tax loss harvesting purposes using individual securities in can be labor intensive and costly. ETF’s are a low cost and easy alternative. For example, if you are holding Microsoft and want to sell it so that you can take the loss, but in the long term you want to keep it in your portfolio, you might want to replace it with the SPDR Technology ETF (XLK). Within this ETF, Microsoft is the largest holding and represents 11% of the portfolio. Chances are that this fund will have a very close correlation in performance to the Microsoft stock. If you want to sell a mutual fund for loss purposes, determine the funds objective and index in which is measures itself. That index can easily be matched off with an index ETF. For example, your international mutual fund can be sold and replaced with the I Shares MSCI EAFE (EFA) Fund.

Another alternative to avoiding the wash sale rule is to double up on the stock or funds’ position. Under this scenario you would buy the same number of shares as the number of shares you want to sell. To avoid the wash sale rule, you will have to hold on to the doubled position for 30 days and then sell the original shares. There are obvious risks here as you have doubled your exposure to this investment.

Here is how the tax benefit works. Capital losses are deductable, dollar for dollar, against capital gains. An investment held for a year or less will be a short term gain or loss. These gains are taxed at your ordinary tax rate. Those longer than a year are long term. You will need to net your gains and losses by either short or long term. Any gains left over can be offset by an additional $3,000 in losses each year.

Be sure to talk with your accountant and advisor before proceeding. In the coming years when the stock market is climbing to new highs you will be grateful for the tax savings.


Susan Templeton

November 2008