For those of you who have funds which are not in tax advantaged accounts, such as IRAs, Roth IRAs, or 529 accounts, the end of 2018 presented opportunities to offset many capital gains from earlier in the year. In your reviews you likely heard the term “tax loss harvesting.” If you found yourself asking, “What does that even mean and how does it benefit me?”, then this article will be for you.
Invested money is often referred to as capital. If the investment made with that capital increases in value and is sold, that capital has produced a gain. That increase in value is taxed as a capital gain. Conversely, if an investment has decreased in value and is sold, then a capital loss is created.
Mutual funds, however, add one other complexity, and that is they often produce capital gains distributions. A mutual fund is simply a pool of money with a management team deciding where to invest that pool of money based on a set of guidelines. When that management team decides to make a change to the fund’s investments, the fund often realizes gains on the investments. A certain percentage of these gains are required by law, to be paid out to the mutual fund’s shareholders, which is accomplished through capital gains distributions. Capital gain distributions are taxable events, even though these distributions are most often immediately reinvested back into the mutual fund. Therefore, for mutual funds, a capital gain or loss created on a sale is determined by the following:
Capital Gain/Loss =Initial Investment + Reinvested Capital Gain Distributions – Current Value.
High income earners are taxed on these capital gains at both the federal and state levels while those in lower income brackets only get taxed at the lower state level. Capital gains can also be offset by capital losses. Therefore, at the end of the year if investments have currently lost money, those investments are sold to capture the loss.
A tenant of successful investing, however, is to not sell at the bottom. So what is done is to immediately reinvest those funds into a very similar investment. For example, a mutual fund that invests in large international companies that lost money could be sold and replaced with a different mutual fund that also invests in large international companies. Doing so keeps the diversification in the portfolio while realizing the loss thereby reducing the amount of taxes owed.
In late December, we as a team go through each and every taxable account. We start by determining the tax status of that client, then look at the amount of capital gains currently in the account, and finally, if necessary, we look to sell any losses and immediately reinvest the proceeds. This process is what we refer to as tax loss harvesting. Because this is quite a task we tend to limit the number of review meetings scheduled after the middle of December.
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