Every investor wants to make as much money as they can on their investments. Unfortunately, not every investment works out and there are going to be some losers along with some winners. Even the best investors will have investments that did not go as expected. Warren Buffet, who many consider to be the greatest investor of our time, has had his fair share of mistakes. You can find a few of those mistakes here.
Investors make mistakes on long term investments that will never come back and they are better off cutting the losses and moving on to something else. There are other times when the investment still makes sense for the long term but for a number of reasons the stock may be trading lower for a period of time. While it may be tempting to simply buy more shares, there are alternatives that could provide you better long term returns. For investors that are using taxable accounts, tax loss selling can be a big boon to your bottom line.
Before I get into the specifics of how this can be very beneficial, let’s first talk about tax rates and tax treatment of capital gains. First of all, you will not pay taxes on investment gains until you actually sell. So in theory, you could hold an investment forever and never pay taxes during your lifetime. Long term capital gains are applied to investments you have held for over 1 year and can be 0%, 15%, or 20% depending on your income. On the other hand, short term capital gains are taxed at your ordinary income rate which can range from 10% to 37% depending on your income. As you can see, the more income you make, the more favorable long term capital gains are for an investor. Additionally, investment losses can be carried forward indefinitely so it is not imperative that you match gains with losses in any particular year.
Tax loss selling is one way to not only delay taxes by pushing them further down the line, but also to help make sure that the gains you do have are being taxed at the most favorable rate. This sounds like a great strategy, but there are a few things to consider before implementing.
#1 – Avoid the wash sale rule
The wash sale rule states that an investor cannot sell a security at a loss 30 days before or after this sale in a substantially identical security. This rule is designed so that investors do not sell a stock at a loss for tax purposes and immediately rebuy the stock. Always make sure that you abide by this 30 day window or your tax sale will be nullified and you will simply generate transaction costs with no economic benefit. If you do not want to sit in cash for those 30 days you can always by another stock, index, or ETF. After the 30 days, you can rebuy the stock and restart the clock towards a 1 year holding period to meet long term capital gains.
#2 – Know your breakeven
This is one of the most important steps of tax loss selling because it allows you to make a decision on whether taking the loss is worth the opportunity cost of a recovery in a stock. In other words, if you take a loss on a stock and in the next 30 days, the stock rises by 100% you would have been better off not doing tax loss selling and just holding the stock. While it is impossible to know for certain what a stock price will do in 30 days, by knowing the different outcomes you can make a more informed decision on the timing of tax loss selling. The best way to illustrate this is with an example. Let’s say you are married filing jointly and make $200,000 a year so your capital gains tax rate is 15% and your income tax rate is 32% (your marginal tax will be lower, but calculating a marginal tax rate is a whole different discussion). Now let’s say that you have $50,000 of realized short term gains that would be taxed at 32% and also have $75,000 of unrealized losses (from a stock you haven’t sold yet). This $75,000 loss consists of 1,000 shares purchased at $175 for a cost basis of $175,000. The current market value is $100,000 or 1,000 shares at $100. If you simply do nothing, you will pay $50,000 *.32 = $16,000 in taxes. If you sell 667 shares of stock in your loser you will generate a $50,000 loss. 667 shares X $175 = $116,725. 667 shares X $100 = $66,700 proceeds. $66,700 - $116,725 = $-50,025. This loss negates your $50,000 gain for the year and ultimately provides a $0 tax liability.
Again, this seems fairly straightforward, but you should also calculate your opportunity cost. In other words, what return would the stock have to have in 30 days to nullify the $16,000 tax savings? The calculation is as follows. $66,700 + $16,000 = $82,700. $82,700/667 shares = $123.98 a share. On a percentage basis, ($123.98/$100)-1 = 23.98%. So, the stock you sold would have to gain 23.98% or more over 30 days to make the tax loss sale a bad decision. By knowing the exact percentage return you can make an assessment on the likelihood of this outcome. However, for simplicity purposes, the higher the percentage needed to break even, the more likely tax loss selling will work for you.
#3 Avoid selling around known stock catalysts
In order to increase the probability that your tax loss selling provides the biggest benefit you should time the sale around well-known stock events. These events would include an ex-dividend date, earnings release, product launch, drug approval, or analyst day. The actual outcome of the stock price around these events is not known for certain, however, the likelihood of an outsized stock move or upside surprise is much greater than on a normal trading day. For an ex-dividend date, selling the day after still provides the investor with the cash flow from the dividend and plenty of time to get back in the stock before the next ex-dividend date. Other events that could cause an outsized move would be an acquisition, going private, or stake from an activist investor. These events are impossible to predict and thus difficult to factor into the analysis.
By using the right techniques, tax loss selling can improve near term tax liabilities and also help you manage your tax rate over time. While no one ever wants to have losers in a portfolio, the reality is that it is inevitable. By applying these techniques you can help improve your long term returns and also increase the amount of money in your pocket. After all, outside of making more money, isn’t everyone’s goal to keep more of what they make?