As the days and long nights of 2002 dwindle to a precious few, individual investors' thoughts turn to, yes, taxes. Specifically, to next April's tax bills and how they might be cut by recognizing investment losses before yearend. Yet whenever my own thoughts turn this way, they swiftly skid off toward Jimi Hendrix, as the variety of so-called "tax-loss harvesting" strategies inevitably leaves me in a purple haze of confusion.
If capital gains, losses, and the tax code zone you out, too, then you know why I was quick to check out some fresh academic research into investment taxes. Twenty years have passed since economists first looked closely at juggling a portfolio's gains and losses to yield the highest ultimate after-tax return. Yet some of the conclusions are contradictory, and most flow from the kind of otherworldly models that are so pleasing to academics--and unhelpful to everyday investors. So a trio of finance professors at Indiana's Ball State University went looking for practical answers, which they presented in November's Journal of Financial Planning.
The profs--Terry Zivney, James Hoban Jr., and John Ledbetter--wanted to know which of two tax-loss harvesting strategies would leave them richer: the traditional approach of selling losers, deducting the capital losses from taxable income, and reinvesting the proceeds; or a more aggressive strategy that, besides selling losers, calls for selling stocks with long-term gains and reinvesting in the same stocks? The second scheme, while it means a capital-gains tax on the winners, resets their tax basis at a higher level, lessening the future tax bite. The researchers also looked at how a simple buy-and-hold strategy, with no losses taken or taxes paid until the portfolio was liquidated, would pan out. They tested the data by simulating market conditions that resemble the long-term behavior of stocks (table).
What did they learn? Most people most of the time are better off using the loss-harvesting strategy of selling losers and letting winners ride. Much math went into that simple statement, and from it I have settled on answers to three questions that keep bugging me:
-- Should I sell all of my losers or just enough for $3,000 in losses? The most in net capital losses that Uncle Sam lets taxpayers deduct against other income is $3,000 a year. But it makes perfect sense to recognize all losses each year and carry forward to future tax years anything above $3,000. "People don't like to realize losses, but they have to get over it," says Vanguard Group tax specialist Joel Dickson. "Losses are an asset--take advantage."
-- Should I also sell some winners to reset their tax basis at a higher level? No, at least not if my sole goal is a higher aftertax return on investment. If, instead, I have the added goal of trying to better diversify my portfolio by selling winners and reinvesting in other stocks or funds, then yes. In that case, I might lower my portfolio's risk at little cost by offsetting realized gains with losses.
-- Should I sell mutual-fund shares even if it means paying a redemption fee? Probably yes. More and more mutual funds force investors to pay a toll when selling shares. In these cases, as with brokerage commissions or any other transaction cost, here's the only question to ask: Is the cost of trading less than my tax savings? If so, then by all means make the trade.
Managing investments for a high total return is hard enough, never mind the taxes. But the time to do both is right now.