The holiday season is upon us.
And with it, a chance for investors to potentially reduce their tax bill.
With all its volatility, this year—at least for now—has delivered many gains for investors. With the S&P 500 up about 10%, and tech-heavy Nasdaq ahead by 30% year to date, we have a lot to be thankful for.
But just how much of these gains will end up in your pockets—versus being paid in taxes?
This is where three tax-smart techniques come in… with the potential to generate significant savings.
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No. 1: Tax-loss harvesting
Applicable to taxable accounts, tax-loss harvesting generally means maximizing the value of capital losses… while netting these losses against capital gains.
If you sell a position at a higher price than your cost basis, you generate a capital gain… and if you sell a position at a lower price than its cost basis, you generate a loss.
Currently you can offset capital gains—either now or in future—by selling a losing investment. Up to $3,000 in investment losses can be claimed against your income for federal taxes. If you have more, you’re allowed to carry over the rest into future years.
Tax-loss harvesting is practiced by some investors all year round. But for many, it’s a necessary year-end step to help reduce a potential tax bite.
Regardless of how you do it, the fiscal year ends on December 31. Any losses taken after that will be counted for the next tax year. The last trading days of December 2020, therefore, would be your last chance to sell a losing position in order for the losses to be counted this year.
In other words, by getting rid of your portfolio losers, you should be able to offset some of your gains. And, typically, you can repurchase a sold position later.
If you do this, however, you should remember to follow rule No. 2—one of the most important tax-related rules for investing and trading…
No. 2: Avoid “wash sales”
The intention of the rule: To make sure investors don’t take losses for the sake of tax benefits while immediately repurchasing the same security.
The wash sale rule requires that, in order to be treated as a tax loss, no “substantially identical” security should be bought within 30 calendar days before or after the sale.
Otherwise, a tax loss will be disallowed.
Note that this rule calls for a 30-day or longer “waiting period,” regardless of the calendar year. This means you should always wait for at least 30 days until you can repurchase the sold security—or a “substantially identical” one.
Plus, the wash sale rule applies across all your investments, including taxable and tax-deferred accounts.
No. 3: Beware of capital gain distributions from mutual funds
At year end, many mutual fund and exchange-traded funds (ETFs) distribute capital gains. If you own such a fund in your taxable account, these distributions will be a taxable event, regardless of how you get them (paid out in cash or reinvested in the fund).
The amount of these distributions depends on the fund’s investments strategies—some trade a lot and others boast a low turnover. The latter are often more tax efficient. You should keep an eye on all your mutual funds, though, regardless of their strategy, especially in a volatile year like 2020.
This year, many funds—even tax-efficient ones—have been able to book significant profits, so they may end up distributing sizable capital gains.
Mutual funds estimate year-end capital gains and dividend distributions and report them—as well as the estimated payout date—on their websites.
The largest fund family, Vanguard, is one example.
In a few days, Vanguard will list the mutual funds and ETFs expected to distribute taxable capital gains, with scheduled record dates and preliminary capital gains estimates, as of October 31.
And on December 9, Vanguard will update this data, estimating what it expects for applicable Vanguard mutual funds and ETFs as of December 31.
Your own fund is likely to have a different schedule… make sure to review it. Many funds will begin their distributions fairly soon, in early to mid-December.
And if you’re thinking about buying a mutual fund, this is key: All fund owners are responsible for the distribution, regardless of when you originally bought shares.
How to avoid the tax bite?
For some of you, selling preemptively might help.
Further, reinvested capital gain distributions can help you with your future taxes. That’s because of the cost basis step-up effect.
Let’s say you paid $100 for 10 shares of a mutual fund that later distributes a 10% capital gain. Assume it was a great fund, and its share price is now $20 (your investment is now worth $200). Also assume you’re reinvesting your capital gain distribution of $20 by buying one more share of the fund.
As a result, you’ll own 11 shares at the total cost of $120. Your old cost basis was $10 per share ($100/10), and your new cost basis will be higher: $10.91 ($120/11) per share. You’ve paid taxes on this year’s distribution, but will owe relatively less if you decide to sell the fund down the road.
Remember to keep track of the reinvested amount—this information will be helpful when you decide to sell.
Of course, the usual disclaimers apply: Consult your tax advisor before making any changes. Everyone’s situation is different, and you’ll be well advised to consult your accounting professional before making important tax-related decisions.
Further, you should never sell a position solely for the sake of booking a loss—or for the sake of taking a gain.
Since you can save money on taxes, but only investments can make you money, any tax strategy should be secondary to your long-term investment strategy.
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