Reducing Year-End Taxes on Your Investments
Nobody wants additional taxes for the holidays, so throughout the year, we look for ways to minimize them. With year-end approaching, it’s a good time to review a few strategies that can potentially reduce your tax bill.
The goal of tax loss harvesting is to stay in the market while capturing the current loss to offset future gains. This involves temporarily selling securities in taxable accounts at a loss, buying something close but not “substantially identical,” and holding it for 30 days to satisfy the IRS rules. After thirty days, you can sell and buy back your original holding and recognize the loss for tax purposes. Any unused losses can be carried forward for your lifetime.
It’s best to do this opportunistically (i.e., when opportunities present themselves) versus only at year-end. This is one reason we review our portfolios frequently throughout the year.
These opportunities tend to dry up during strong markets like 2021. But sometimes, the opportunity is still out there depending on the investment and timing of purchase.
It’s important to note this strategy only applies to taxable accounts. You cannot recognize losses in qualified accounts such as IRAs or 401(k)s, for example.
Distributions generally consist of dividends and capital gains from the underlying investments in a fund. Capital gain distributions result from the mutual fund selling securities at a gain, and distributing those gains to shareholders. There are three important dates to understand:
- The Record Date –the cutoff date to determine if you are eligible to receive distributions.
- The Ex-Dividend Date –If you own the investment before this date, you get the distribution (normally the following day).
- If you buy it on or after this date, you do not get the distribution.
- The investment price drops by roughly the amount of the distribution.
- The Pay Date – when you receive the cash, which is at least a day after the ex-dividend date.
Here’s an example of how it works:
- An investment is worth $100/share and will pay a $10/share distribution.
- Record Date – nothing happens. But if you own it on this date, you’re eligible to receive the $10.
- Ex-Dividend Date –The share price drops by $10 (the distribution amount) to $90.
- Pay date (the next day) – you get $10 of cash.
In the end, you still have $100 if you add the two together. The only difference is that if held in a taxable account, $10 is now taxable.
What can you do? Avoid buying investments with high expected distributions right before they pay. Otherwise, you are buying into a taxable event without increasing the value, as the above example illustrates. Again, in qualified accounts, this is not an issue since there are no taxes unless you withdraw the funds from those accounts.
What else? You can look to sell your fund before the distribution and buy something else. Keep in mind; this can work if the taxable distribution is greater than the embedded gain. Otherwise, you may pay more tax by selling the fund than you would by holding it and receiving the distribution. If the investment has an unrealized loss, selling it to capture the loss and avoiding the gain can be a great strategy.
With such a strong market, however, such opportunities may be limited. But if we can find them, rest assured we will capitalize on them. We will also use that as an opportunity to rebalance your portfolio with the cash received. Therefore, you may see some trading activity between now and year-end as a result.
Hopefully, this should serve as guidance for your outside accounts and let you know what to expect between now and year-end. Enjoy the holidays, and hopefully higher after-tax returns as well.
Gary is a Wealth Manager at BDF and member of the Firm’s Investment Committee. He specializes in executive and stock-based compensation plans, including stock options, restricted stock and deferred compensation. He combines his tax knowledge, executive compensation experience and capital markets expertise to help clients reduce their tax burdens and achieve each of their unique goals.