River Hill Magazine: Stock Market Turmoil Presents Opportunities to Reap Tax Savings

Stock Market Turmoil

This has been a challenging year for stock market investors. Year-to-date through the quarter ending September 30, 2015, the total U.S. stock market was down over 6% and emerging market stocks were down over 17%! The challenges stem from a myriad of problems centered on the global impact of slowing economic growth in China.

Opportunity: Harvesting Tax Losses

One way to economically benefit from stock market losses is to sell some losing investments in taxable accounts. Behavioral finance professors remind us that this counterintuitive strategy is an emotionally difficult decision for many investors to make. Investors often prefer to continue to hang on to losing positions “until they bounce back”. Selling a position at a loss effectively locks in that loss by converting an unrealized loss on paper to a realized loss. By utilizing the technique of “harvesting tax losses”, an investor can actually increase after-tax income by paying less tax.

This year’s down market has an upside.  Three advantages come to mind by selling securities that are worth less than you paid. These advantages are: reducing taxable income, pruning away unwanted securities and repositioning “tax-ugly” investments.

  • Reducing taxable income: Offset your gains with losses.  If you rebalanced your winners earlier this year by banking some profits on the sale of highly appreciated healthcare or technology stocks before the recent correction, you likely face higher taxes on these realized capital gains.  You can offset such gains with corresponding losses that you may have from the sale of beaten-down industrial or energy stocks.  If you have, for instance, $10,000 in long-term gains and can take $10,000 in long-term losses, they will cancel each other out.
  • Pruning away unwanted securities: Prune investments that no longer play an important role in the structure of your total portfolio and get a tax benefit at the same time if you sell at a loss. It is important to review all of your investments periodically and understand why you hold each position. What role does each security play in your total portfolio – safety, liquidity, income, long-term growth, diversification, inflation protection, etc? If a particular security does not have a defined purpose in your overall plan, perhaps it is time to sell.
  • Repositioning “tax-ugly” investments: The third advantage mentioned above is to remove “tax-ugly” investments from taxable accounts.  “Tax-ugly” investments throw off high, non-qualified dividends that are fully taxable at ordinary income tax rates. The income generated by these securities is not taxed at lower, more favorable qualified tax rates assigned to dividends from most common stocks or capital gains. Whenever possible, it is best to hold tax-ugly investments inside of tax-deferred accounts.

Here are three points to keep in mind as you look for opportunities to capture tax savings at year-end:

  1. Tax consequences are an important investment factor to consider, but not the only one, and rarely the most important factor.
  2. You can’t generate income tax losses by selling securities held in tax-deferred accounts like 401(k) plans or individual retirement accounts.
  3. You can’t sell an investment at a loss and buy it back within 30 days.  That will trigger “wash sale” rules that would nullify the tax loss.  Replacing it with a similar but not identical security can avoid that problem.

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River Hill resident, Christopher P. Parr, CFP®, is president of Parr Financial Solutions Inc., a Columbia-based, independent, fee-only wealth management firm. He can be reached at 410-740-9011 or on-line at www.ParrFinancialSolutions.com. Be sure to mention Living at the Hill!