Each December, I review taxable accounts and look at each investor’s tax situation for the year. I selectively harvest positions with a loss so those losses may offset any capital gains realized by sales or distributed by your funds this year. If realized losses exceed gains, $3,000 of the losses may be applied against your ordinary income and any excess loss is carried forward into future years.
Depending on the time of your purchases, some investors have small losses in International and Emerging Market stocks for the year. Although these positions may be down and have lagged US stock indices, I’m not suggesting that we abandon an allocation to these categories altogether.
What we can do is swap from one ETF (or mutual fund) to another ETF or fund in the same category. This enables us to maintain our overall target allocation while still harvesting the loss for tax purposes. And thankfully, with a proliferation of low-cost ETFs available in most categories today, it is easier than ever to make a tax swap while maintaining our desired investment allocation.
Tax loss harvesting reduces taxes in the current year, but is primarily a deferral mechanism, as new purchases at a lower cost basis will have higher taxes in the future. Still, there is a value to the tax deferral, plus a possibility that an investor might be in a lower tax bracket in retirement or could avoid capital gains altogether by leaving the position to their heirs or through a charitable donation.
Most of our ETFs have no taxable capital gains distributions for 2014, a nice feature of ETFs compared to actively managed mutual funds, many of which are generating sizable distributions, even for new shareholders. Focusing on individual after-tax returns is another way we can add value for our clients.
If you’d like to study tax loss harvesting in greater detail, I recently read an excellent article, Evaluating The Tax Deferral And Tax Bracket Arbitrage Benefits Of Tax Loss Harvesting, by Michael Kitces.