If capital gains, losses, and the tax code zone you out, too, then you know why I was quick to check out some fresh academic research into investment taxes. Twenty years have passed since economists first looked closely at juggling a portfolio's gains and losses to yield the highest ultimate after-tax return. Yet some of the conclusions are contradictory, and most flow from the kind of otherworldly models that are so pleasing to academics--and unhelpful to everyday investors. So a trio of finance professors at Indiana's Ball State University went looking for practical answers, which they presented in November's Journal of Financial Planning.
The profs--Terry Zivney, James Hoban Jr., and John Ledbetter--wanted to know which of two tax-loss harvesting strategies would leave them richer: the traditional approach of selling losers, deducting the capital losses from taxable income, and reinvesting the proceeds; or a more aggressive strategy that, besides selling losers, calls for selling stocks with long-term gains and reinvesting in the same stocks? The second scheme, while it means a capital-gains tax on the winners, resets their tax basis at a higher level, lessening the future tax bite. The researchers also looked at how a simple buy-and-hold strategy, with no losses taken or taxes paid until the portfolio was liquidated, would pan out. They tested the data by simulating market conditions that resemble the long-term behavior of stocks (table).
What did they learn? Most people most of the time are better off using the loss-harvesting strategy of selling losers and letting winners ride. Much math went into that simple statement, and from it I have settled on answers to three questions that keep bugging me:
-- Should I sell all of my losers or just enough for $3,000 in losses? The most in net capital losses that Uncle Sam lets taxpayers deduct against other income is $3,000 a year. But it makes perfect sense to recognize all losses each year and carry forward to future tax years anything above $3,000. "People don't like to realize losses, but they have to get over it," says Vanguard Group tax specialist Joel Dickson. "Losses are an asset--take advantage."
-- Should I also sell some winners to reset their tax basis at a higher level? No, at least not if my sole goal is a higher aftertax return on investment. If, instead, I have the added goal of trying to better diversify my portfolio by selling winners and reinvesting in other stocks or funds, then yes. In that case, I might lower my portfolio's risk at little cost by offsetting realized gains with losses.
-- Should I sell mutual-fund shares even if it means paying a redemption fee? Probably yes. More and more mutual funds force investors to pay a toll when selling shares. In these cases, as with brokerage commissions or any other transaction cost, here's the only question to ask: Is the cost of trading less than my tax savings? If so, then by all means make the trade.
Managing investments for a high total return is hard enough, never mind the taxes. But the time to do both is right now. By Robert Barker