There are few upsides to the investment losses you've suffered over the past year. But there is one: If you're smart about taxes, you can eke out more returns from your portfolio this year and enjoy tax-free gains for years to come.
Investors don't like to take losses, but savvy investment managers know just how much tax management is worth. A study by money manager First Quadrant in Pasadena, Calif., based on a widely diversified portfolio, found that tax-loss harvesting—the regular culling of a portfolio to get the most out of losses—could add as many as seven percentage points to the return in the first year; even after 25 years it could add 0.3 percentage points, a still-significant amount.
"As an investor, you want to take losses all the time to the extent that you can," says Andrew Berkin, senior equity researcher at First Quadrant and co-author of that study. "An individual investor can carry forward losses indefinitely, so while none of us know what the markets are going to look like or when they are going to recover, there are going to be plenty of opportunities to have gains."
To understand how to benefit from tax-loss harvesting, you need to know how the tax rules work. The key point is: The tax code lets you offset gains with losses. You first match short-term gains (on investments held for one year or less) with short-term losses, and long-term gains (those on investments held more than one year) with long-term losses; only then do you determine what the net effect of your losses and gains will be.
Losses Now to Offset Future Gains
Because long-term gains are taxed at the favorable capital-gains rate of 15%, and short-term gains are taxed at regular income-tax rates of up to 35%, short-term losses are more valuable. If the result of matching gains and losses is a net loss, you can take up to $3,000 against your income. If you have a larger net loss than that, you can roll it over—in tax lingo, it's a capital-loss carryover—to offset gains in 2010 and beyond. If the tax rates on capital gains or income rise, as most tax experts believe they will, taking capital losses now will be worth more in the future, since they can offset gains that would be taxed at a higher rate.
Consider what this means in real life: If you book a long-term capital gain of $10,000 this year without an offsetting capital loss, you'll owe the IRS $1,500 even if you have thousands of dollars in paper losses in your portfolio. If you take an equivalent $10,000 capital loss, you'll owe no capital gains. And if you take a $13,000 loss, you can book that $3,000 net capital loss against regular income, for an additional savings (in the 35% tax bracket) of $1,050. Your total tax savings for this simple move: $2,550.
Who gains the most from tax-loss harvesting? Those who trade actively in an effort to make money off market volatility will gain substantially by having short-term losses to balance against trading gains. So, too, will anyone with tax-inefficient investments, such as hedge funds. Those who have big positions they've held for a long time, and thus have hefty long-term gains despite the current market, can also get a lot out of tax management.
Of course, you'll want to make sure taxes aren't your only motivation for selling; a sale should, first and foremost, be based on a sound investment strategy. With the mix for many investors altered by the market volatility, it's not a bad time to see what your portfolio looks like now vs. the asset allocation you intended. Since it's tax time, you have a good sense of whether you already have a stockpile of capital losses from last year, or whether you didn't take enough of them despite the market's decline. "A lot of people are going to have capital-loss carryforwards from 2008, so before you make a decision about loss harvesting you need to see how much of a loss carryforward you already have," says John Battaglia, director of private-client advisers at Deloitte Tax.
One smart strategy is to use losses from the sale of a stock you no longer like to offset gains from the sale of another stock you do like. By doing this, and then buying back the stock you like, you will readjust the cost basis on which future taxes will be calculated, while paying no tax on the difference between your original cost and that new basis. (To be sure this is worth doing, take transaction costs into account.) "That puts you in a much more advantageous position in the future," says Douglas Rogers, chief investment officer at Laird Norton Tyee in Seattle and author of Tax-Aware Investment Management: The Essential Guide.
To get the most out of those losses, you'll need to be savvy about just how you account for them on your taxes. The IRS allows taxpayers a number of methods for calculating the cost basis of investments, which can result in wildly divergent tax bills for any one year. First Quadrant, which manages all their portfolios on a tax-efficient basis, argues that the best way to book capital gains and losses is with highest in, first out (HIFO). This method assumes the most expensive shares are sold first, generating the smallest capital gains and the largest capital losses. Especially if your position is large, identifying specific shares will get the most tax benefit from your portfolio and be worth the record-keeping aggravation.
The Tricky Wash-Sale Rule
If you are taking losses now, don't forget the wash-sale rule. That's the tricky IRS regulation that prohibits you from taking a loss on an investment if you buy new shares within a period that begins 30 days before the date of the sale and ends 30 days after—a total of 61 days. Dividend reinvestments and automatic purchases count toward the wash-sale rule. While you can't buy the exact same stock or fund during that period, you could sell one actively managed large-cap mutual fund and buy another one.
If you are stockpiling losses, how much is the right amount? That's a question only you can answer. But if you plan to be investing for many years and expect the market to recover eventually, that amount may be higher than you think. "After 2000-02, people said: 'I have all the losses I can use for the rest of my life,'" recalls First Quadrant's Berkin. "But as the markets recovered, there were plenty of gains and plenty of opportunities to use those losses."