By Mark Painter, CFA
Every investor wants to make as much money as they can on their investments. Unfortunately, not every investment works out and there are going to be some losers among the winners. Even the best investors will have investments that don't go as expected. Warren Buffet, who many consider to be the greatest investor of our time, has had his fair share of mistakes.
Investors make the mistake of holding on to long-term investments that will never come back when they would be better off cutting their losses and moving on. There are other times when the investment still makes sense for the long-term, but for a number of reasons the stock may be trading lower for a period of time. While it may be tempting to simply buy more shares, there are alternatives that could provide you better long-term returns.
For investors who are using taxable accounts, tax-loss selling can be a big boon to your bottom line. Before I get into the specifics of how it can be beneficial, let’s first talk about tax rates and tax treatment of capital gains. You won't pay taxes on investment gains until you actually sell, so in theory, you could hold an investment forever and never pay taxes during your lifetime. Long-term capital gains are applied to investments you have held for over one year and can be 0%, 15% or 20%, depending on your income.
On the other hand, short-term capital gains are taxed at your ordinary income rate which can range from 10% to 37%, depending on your income. As you can see, the more income you make, the more favorable long-term capital gains are for an investor. Additionally, investment losses can be carried forward indefinitely so it is not imperative to match gains with losses in any particular year. (For related reading, see: Comparing Long-Term vs. Short-Term Capital Gains Tax Rates.)
Tax-loss selling is one way to not only delay taxes, but also to help make sure the gains you do have are being taxed at the most favorable rate. This sounds like a great strategy, but there are a few things to consider before implementing.
1. Avoid the Wash-Sale Rule
The wash-sale rule states an investor cannot sell a security at a loss then buy a substantially identical security within 30 days after the sale. This rule is designed so investors do not sell a stock at a loss for tax purposes and immediately repurchase the stock. Always abide by this 30-day window or your tax sale will be nullified and you will simply generate transaction costs with no economic benefit.
If you do not want to sit on cash for those 30 days, you can always by another stock, index or exchange-traded fund (ETF). After the 30 days, you can repurchase the stock and restart the clock towards a one-year holding period to meet long-term capital gains.
2. Know Your Breakeven
This is one of the most important steps of tax-loss selling because it allows you to make a decision on whether taking the loss is worth the opportunity cost of a recovery in a stock. In other words, if you take a loss on a stock and in the next 30 days the stock rises by 100%, you would have been better off not doing tax-loss selling and just holding the stock.
While it is impossible to know for certain what a stock price will do in 30 days, knowing the different outcomes will help you make a more informed decision on the timing of tax-loss selling. The best way to illustrate this is with an example.
If you are married filing jointly and make $200,000 a year, your capital gains tax rate is 15% and your income tax rate is 32%. Let's say you have $50,000 of realized short-term gains that would be taxed at 32% and also have $75,000 of unrealized losses (from a stock you haven’t sold yet). This $75,000 loss is the result of 1,000 shares purchased at $175 each which are now worth only $100 each in the current market.
If you simply do nothing, you will pay $16,000 in taxes ($50,000 x .32 = $16,000). If you sell 667 shares of your losing stock, you will generate a $50,000 loss:
- 667 shares x $175 = $116,725
- 667 shares x $100 = $66,700 proceeds
- $66,700 - $116,725 = $-50,025
This loss negates your $50,000 gain and therefore your tax liability.
This seems fairly straightforward, but you should also calculate your opportunity cost. What return would the stock have to have in 30 days to nullify the $16,000 tax savings? Use the following calculations to find out:
- $66,700 + $16,000 = $82,700
- $82,700/667 shares = $123.98 a share
- ($123.98/$100) –1 = 23.98%
So, the stock you sold would have to gain 23.98% or more over 30 days to make the tax-loss sale a bad decision.
By knowing the exact percentage return, you can make an assessment on the likelihood of this outcome. However, for simplicity purposes, the higher the percentage needed to break even, the more likely tax-loss selling will work for you. (For related reading, see: 3 Tips to Get Started on Tax-Loss Harvesting.)
3. Avoid Selling Around Known Stock Catalysts
To increase the probability your tax-loss selling provides the biggest benefit, you should time the sale around well-known stock events. These events would include an ex-dividend date, earnings release, product launch, drug approval or analyst day. The actual outcome of the stock price around these events is not known for certain. However, the likelihood of an outsized stock move or upside surprise is much greater than on a normal trading day.
For an ex-dividend date, selling the day after still provides the investor with the cash flow from the dividend and plenty of time to get back in the stock before the next ex-dividend date. Other events that could cause an outsized move would be an acquisition, going private or stake from an activist investor. These events are impossible to predict and thus difficult to factor into the analysis.
Improve Your Long-Term Returns
By using the right techniques, tax-loss selling can improve near-term tax liabilities and help you manage your tax rate over time. While no one ever wants to have losers in a portfolio, it's inevitable. By applying these techniques you can help improve your long-term returns and increase the amount of money in your pocket.
(For related reading, see: Tax-Loss Harvesting: Reduce Investment Losses.)
This article was originally published on Investopedia