By RICK FERRI
Tax-loss harvesting and security swapping makes lemonade out of a lemon investment. The concept is simple. Sell a security in your taxable account that’s at a loss to take a tax benefit this year, and simultaneously buy a similar security to replace the one you sold to maintain your position in the market. There is one caveat. You cannot buy a substantially identical security within 30 days of the sale because the IRS will not allow the loss.
Tax-loss harvesting only works in taxable investment accounts such as an individual account, joint account, and taxable trust accounts. Individual retirement accounts like traditional IRAs and Roth IRAs, and qualified retirement accounts like the 401k and the 403b are not subject to taxation. You can’t use losses from non-taxable accounts to offset gains in your taxable accounts.
Reduce your tax liability
Selling securities that have losses in accounts that pay taxes can reduce your tax liability. You can use the loss to offset capital gains that result from selling securities at a profit anytime this year and can offset capital gain distributions from mutual funds. If you don’t have any gains, you can use the loss to offset up to $3,000 in non-investment income. Tax losses carry forward over your lifetime, and if you’re married, through your spouse’s lifetime. They do not pass to heirs.
Let’s say that you have $25,000 capital gain on the sale of a mutual fund in a taxable investment account. If you sell another fund that’s at a $25,000 loss, the loss will offset your gain, and there will be no taxes due. You could also buy a similar fund so that you’re not out of the market. This is called swapping and protects your position if the market rebounds.
Here is an example; sell Vanguard Total Stock Market ETF (VTI) at a loss and buy iShares Core S&P Total U.S. Stock Market ETF (ITOT) to replace it. These are similar index funds but not substantially identical because the securities are issued by unrelated investment companies and track different US market indices.
You can swap back to VTI after 30 days if you prefer, but don’t do before 30 calendar days in any account that you or your spouse own. That’s a tax wash. You’ll lose the benefit from the loss. If the stock market continues down during the 30-day period and you want to take another loss, you could sell ITOT and swap into a third fund such as the Schwab U.S. Broad Market ETF (SCHB) or the SPDR Portfolio Total Stock Market ETF (SPTM). All these ETFs are interchangeable.
Here is a second example of tax-harvesting and swapping using international stock ETFs. Sell Vanguard Total International Stock ETF (VXUS) at a loss and buy iShares Core MSCI Total International Stock ETF (IXUS). If the stock market continues down during the 30-day period, do another tax-harvest by selling IXUS and swapping into Vanguard FTSE All-World ex-US ETF (VEU). These ETFs track broad international stock indices that are licensed from different index providers and are not substantially identical.
The IRS has many rules surrounding how a tax loss can be used as you would expect. A loss can offset both long-term capital gains and short-term capital gains that are held one year or less, but there is a sequence to applying the loss. A long-term loss is applied first against long-term gains and then short-term gains. A short-term loss is applied first to against short-term gains and then long-term gains. The IRS does it this way because long-term capital gains are taxed at a lower tax rate than short-term capital gains.
Does it just delay the inevitable?
Some advisers will say tax-harvesting and swapping only delays an inevitable capital gains tax because taxes will be due when the securities are sold. That might be true if you sell, but it depends on how much income you’re earning at the time. If your income is lower, you may pay a lower capital gains tax, and if your income is below a certain level, there is no capital gains tax.
Also, you would need to sell the securities to have a capital gains tax, and that’s not something you ever have to do. The appreciated securities can be donated to charity, which may also make you eligible for a tax deduction on the fully appreciated value without paying capital gains tax. Also, if you pass away, your heirs will get a stepped-up basis, and they will not have to pay capital gains tax.
Consult your tax adviser to see if you can take advantage of tax-loss harvesting and security swap strategy.
RICK FERRI runs Ferri Investment Solutions, a pay-by-the-hour financial advice service, and is based near Austin, Texas. You can follow him on Twitter @Rick_Ferri.
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