We all get satisfaction when we make money on the sale of a stock, yet these gains can come with the nasty surprise of hefty tax bills. Losses, on the other hand, can be hard to swallow. The good news is that losses may come with a silver lining in the form of potential tax benefits.
“Tax-loss harvesting,” as it is known, allows investors to offset gains realized in one investment with losses incurred in another.* The following hypothetical example illustrates how this technique can help reduce an investor’s tax liability.
Following a few general guidelines could help you take advantage of this opportunity and may help avoid running afoul of the IRS’s wash sale rule. Remember everyone's situation is different. Please consult a tax advisor for your individual situation.
As year-end approaches, take the opportunity to review each portfolio’s capital gains tax exposure as part of your holistic approach to financial planning.
And following is an overview of some recent changes in tax law that you should keep in mind in tax planning.
The IRS’s wash sale rule is designed to keep investors from claiming artificial losses, so it’s critical to understand it if you’re planning to harvest losses.
The rule prohibits the sale of a security in order to claim a loss if the investor repurchases it – or a “substantially identical” security – within 30 days before or after the sale. Violating this rule could negate any potential tax benefits from the transaction.
How does the IRS define “substantially identical” security? Unfortunately, they have not identified specific criteria.** Nevertheless, to determine the potential for a wash sale violation, there are some factors that investors may want to consider, including the degree of holdings overlap and the difference in prospective returns. The greater the holdings overlap and the more similar the prospective returns, the greater the possibility of a wash sale classification by the IRS.
Many investors consider ETFs as well as active and indexed mutual funds as effective tools to gain desired portfolio exposures. Yet it’s important to exercise caution to avoid violating the wash sale rule. The following framework provides an overview of the extent to which ETFs, active mutual funds, and index mutual funds may feature low portfolio overlap as well as differences in prospective returns under various scenarios.
*Long- and short-term capital gains are taxed at different rates. Long-term gains may only be offset by longer-term losses. Likewise, short-term gains may only be offset by short-term losses.
**As of 11/30/2018, the Internal Revenue Service has not released a definitive opinion regarding the definition of “substantially identical” securities and its application to the wash sale rule and ETFs. The information and examples provided are not intended to be a complete analysis of every material fact and are presented for educational and illustrative purposes only. Tax consequences will vary by individual taxpayer and individuals must carefully evaluate their tax position before engaging in any tax strategy.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.