Harvesting Losses

Last week we touched on typical year-end topics like taking Required Minimum Distributions and how portfolio rebalancing can help free up the necessary cash. Now let’s look at an unfortunate reality for this year-end: harvesting losses.

If you’re like most investors your portfolio is probably showing some losses right now. And if you were paying attention you likely saw losses ebb and flow starting in about March. Even if you harvested back then or perhaps multiple times already it likely makes sense to look again. Markets have continued to struggle and, even though prices have recovered a bit in recent weeks, losses remain.

Take a look at this simple chart of four broad market index funds to see how there were several major lows where you could have harvested as the year progressed.

There are different schools of thought on this, but I think harvesting losses is worthwhile for two primary reasons: one, if done correctly harvesting losses lowers your household’s tax bill and this helps to indirectly increase your investment performance; two, for the most part we don’t have to worry about transaction costs, so the only direct cost associated with harvesting losses is your time. By the way, I think this last point feeds into some of the criticism (if that’s the correct word) of harvesting losses. It’s time consuming and requires holding a lot of details, and that often makes it difficult for some people, including professional money managers, to want to bother with it.

Here’s a primer on how this works. As a reminder, tax loss harvesting only applies to your individual accounts, trust accounts, and so forth, not to your retirement accounts. Ask your tax advisor (or me) for more details.

First things first – Why do we want to do this?

Losses in our investment accounts are unrealized (often called paper losses) until we sell and realize them. Nobody wants to lose money and eventually losses on high quality investments will turn into gains. But is it possible to reap some benefits from the low points along the way? That’s what loss harvesting is all about.

Say you bought $10,000 worth of a S&P 500 index fund earlier this year that’s now worth $8,000, for a $2,000 unrealized loss. This is a core holding and the fund is high quality, it’s just down with the market. What should you do?

You could simply hold the investment as a long-term investor should. There’s nothing necessarily wrong with that. But what about that unrealized loss… shouldn’t we try to find a silver lining? I say yes!

You do this by selling the investment (you can sell a portion but let’s assume you sell the whole thing) and not rebuying it for at least 30 days. You also shouldn’t have bought any shares during the prior 30 days. This is tracked by your brokerage firm and creates a 60-day window around whatever date you’re thinking about selling shares. Once you’re out for that long you have realized a capital loss and can use it to offset capital gains from other sales or those pesky taxable year-end mutual fund gain distributions. And if you have losses left at year-end you can use up to $3,000 as a tax deduction. Remaining losses carry over until fully used. In other words, losses are valuable at tax time.

While you’re welcome to sit in cash for a month or so after selling the investment, you can and should buy something else while you wait. And this is actually the goal from a portfolio management standpoint – to not rock the boat too much in terms of your investment mix. The tricky part is the new investment is essentially a placeholder that can’t be overly similar to what you just sold, or you risk triggering what’s called a wash sale and invalidating your loss. And this applies to all of your family’s accounts. No selling in yours and buying back immediately in your spouse’s account or selling in your brokerage account and then immediately buying back in your Roth IRA.

The details get complicated, but a simple approach to finding a placeholder is to change management style or regions. For example, if you’re selling a passively managed ETF like the S&P 500 fund, SPY, you could use an actively managed mutual fund that owns large cap US stocks. Or you could use a foreign ETF in place of a domestic ETF. It’s not perfect but keeps you invested. That way if markets rise during the month or so while you’re out of SPY you’re still getting some benefit. And if you own SPY in multiple accounts, remember that you’re only selling shares in your non-retirement account, so you still have exposure to the S&P 500, just less for a while. Worse case, you’ll have some gain when you sell your placeholder that uses up some of your harvested loss. But that’s a great problem to have, right? Or maybe markets continue to fall, and you harvest more losses when moving back into your original investment.

The thinking is similar with bond funds in terms of swapping management style and bond categories. For example, you could sell a medium-term bond ETF that is passively managed and that holds a lot of US Treasurys and swap for a medium-term CA municipal bond fund as a placeholder. This keeps your bond allocation roughly in line until you go back to your original holding. Maybe you decide to keep your placeholder for a while – there’s no rule requiring a roundtrip.

Again, there’s a lot of detail here and I’ve just scratched the surface. The point is that if you haven’t harvested this year I highly suggest taking a look at your unrealized gain and loss information prior to year-end. Or if you harvested months ago, take another look. Maybe you decide to do nothing. At least you’re making an informed decision.

And you don’t have to worry about these details if we’re managing your portfolio – we’ve got you covered.

Have questions? Ask me. I can help.