General investment wisdom holds that the fourth quarter is the time to start looking at realizing investment losses, so as to offset realized gains in an effort to lower the current year tax burden.
The problem with this practice is that it is possible to actually increase your long term tax burden by engaging in such activity. This is where tax loss harvesting comes into play.
Take an example where an investor purchased ABC stock at $20 a share two years ago. Today ABC is trading at $15 and our investor takes a “tax” loss to offset long term capital gains of 15%.
But now if the investor buys a new stock XYZ at $15 a share he/she has a new cost basis and will start being taxed on all investment gains from that date. In addition it will take a year to reach the favorable long term gain status and favorable rate of 15%.
Through tax loss harvesting, if the investor had instead held ABC, (when it was trading at $15) the first 33% (from 15 to 20) of gain from this point forward is in effect tax free. Anything after that (above the cost basis of 20) becomes a gain and taxable, but due to the holding period qualifies for the advantage of the 15% long term rate.
Now of course the theory or practice dictates that the investor can manage the new tax liability by realizing tax losses the following year, but again in the long run this has the effect of making it more difficult to reach the favored long term status of 15%, not to mention the previously mentioned fact of losing “tax free return” of gains in the stock price which occur below the original cost basis.
In my opinion investors should not get to worked up about paying a 15% capital gains rate, it is likely the cheapest income related tax you will pay for some years if not your life time.
By engaging in such tax loss harvesting an investor may or may not be improving his or her long term tax efficiency, but they will certainly be creating transactions and thus commissions that your brokerage firm will be more than happy to collect.
While tax consequences should be taken into consideration (of course with consultation from your tax professional), when making investment decisions, it is imperative that investors not let the tax tail wag the investment dog.
DISCLOSURE AND DISCLAIMER: Nothing in this article should be construed as a personal recommendation or investment advice. Nor should anything in this article be construed as an offer, or a solicitation of an offer, to sell or buy any particular investment security. Investors should conduct their own due diligence and seek the advice of a financial and/or investment professional before making any investment decisions.
Barnhart Investment Advisor is NOT a tax advisor and does not provide specific tax advice. All investment related tax strategies and decisions should be discussed with a qualified tax professional before implementing.