Strategic sales can improve your asset allocation and help alleviate the tax hit typically associated with realignment
Volatile markets can be incredibly stressful, and they can also force compromises that most investors would rather not make. Young accumulators may confront the reality that they will have to save more to reach their long-term financial goals; the market will do less of the heavy lifting for them. Large portfolio declines can force pre-retirees to push back their planned retirement dates, while people who are already retired and drawing from their portfolios may begin contemplating whether they need to scale back their spending.
Yet there is at least a small silver lining to market volatility, and it is one that investors have not been able to take too much advantage of in recent years: tax-loss selling. By selling securities from your taxable account at a loss, you are able to use that loss to offset gainers elsewhere in your portfolio, or up to $3,000 in ordinary income.
Why Do It
Realizing losses is an effective tool to have in your tool kit, especially this year. That is because even factoring in the recent market weakness, many investors’ portfolios are listing heavily toward more aggressive securities, especially stocks. Bringing those portfolios back into alignment necessitates selling appreciated winners, however, and that entails tax costs for
taxable investors. Finding tax losses can help alleviate the tax hit associated with a realignment.
In addition, some professionals suspect it is going to be another banner year for mutual fund capital gains distributions, which can result in a taxable event for shareholders who hold the funds in taxable accounts. Funds typically distribute these gains in the fourth quarter of each year. The same forces that have fueled sizable distributions at many funds these last few years are in place in 2018: Most funds have still-sizable gains on their books and active funds have continued to see redemptions; that forced selling prompts fund managers to sell appreciated securities, thereby triggering distributions. By scouting around for tax losses, investors can reduce the pain associated with those unwanted distributions.
How Tax-Loss Selling Works
Just to be clear, tax-loss selling is typically only a worthwhile strategy within your taxable accounts—not tax-sheltered accounts like IRAs. It is technically possible to realize a loss in an IRA but not usually advisable.
Securities in a portfolio that are trading below your cost basis—the amount you paid for your shares plus commissions you paid and reinvested dividend and capital gains distributions—are prime targets for tax loss selling. (Other corporate actions, such as stock splits, can also affect your cost basis.)
Where it gets tricky, however, is that there are a few different ways of calculating cost basis. Assuming you have purchased shares at different intervals with different share prices, the specific share identification method gives you the best shot at tax losses, enabling you to cherry-pick the shares with the highest cost basis that are most likely to result in a tax loss. Right now, for example, someone using the specific share identification method might unload high-cost shares purchased earlier this year, before the market started to slide, while leaving lower-cost-basis shares in place.
The average method, whereby all of your purchase prices are averaged together, is usually the default method for mutual funds, though you can override it. It is simple and clean, but it obviously does not allow for surgical tax-loss harvesting in the way that specific share identification does. If you have sold shares using the averaging method in the past, you will have to stick with it in the future.
Beware the Wash-Sale Rule
In addition to cost-basis elections, another tricky aspect of tax-loss selling is if you would like to maintain economic exposure to the same part of the market that you are selling out of. In that instance, you need to get familiar with the wash sale rule, which states that buying a “substantially identical” security to the one that you have sold within 30 days of the sale negates your ability to take a tax loss on the sale. For example, you could not sell a fund tracking the MSCI EAFE index and buy an MSCI EAFE-tracking ETF right away instead. You could not swap one share class of a stock for another. But you could sell an actively managed foreign stock fund and buy a foreign stock ETF.
Where Stock Investors Can Look
Investors in individual stocks are the most likely to be able to identify tax-loss candidates at this juncture, simply because it is more likely they would have outlier performers even though the broad market has trended up for the better part of a decade. As of October 29, there were 5,873 stocks in a popular database with losses of more than 10% so far this year; 639 of them were large caps. And 4,376 companies, 289 of them large caps, had posted losses over more than 20% for the year to date.
Note that foreign stocks predominate on the loser’s lists: Of the large-cap stocks that had lost more than 20% so far this year, for example, 94% were foreign stocks. Yet a grab-bag of widely held U.S. large caps have experienced losses of 20% or more so far this year, too.
In terms of sectors, individual-stock investors are apt to find that recently purchased technology positions are a happy hunting ground for tax-loss harvesting. (Here is a spot where specific share identification can be particularly useful.) Among longer-held positions, the basic materials, energy, and mining sectors are flush with stocks that are down not just for the year to date but for periods stretching back a year or even more. Master limited partnerships have logged big losses that stretch back to 2015. In other words, you would not need to be newly arrived in the stocks to have experienced losses.
Where Mutual Fund/ETF Investors Can Look
Mutual fund and exchange-traded fund investors may have a trickier time finding positions that are trading below their cost basis, but it is worthwhile to take a peek. Investors who are using the specific share identification method may be able to unload recently purchased shares at a loss, as most diversified U.S. large-cap funds are in the red so far this year.
Foreign-stock fund holdings will also be a prime hunting ground for tax-loss sales. As of late October 2018, every single foreign stock fund category was in the red for the year to date and over the trailing 12 months. And the diversified emerging-markets category is in negative territory not just for the year to date but over the trailing five-year period. The emerging markets pain has not been confined to equities, either: The smallish category of emerging-markets bond funds that focus on local-currency-denominated debt is also in the red (albeit by just a hair) over the past five years.
Investors employing sector-specific mutual funds and ETFs are also apt to be able to find losing positions. Newly initiated positions in the technology sector could be ripe for the picking, as such funds have plummeted 15% in the past month alone. Investors who have owned shares for a longer period of time will not likely have losses, though; even factoring in the recent losses, the average technology sector fund is nearly in the black year to date. Longer-term fund investors looking to prune losers from their portfolios might instead look to their equity precious metals, commodities, equity energy, and/or energy limited partnership funds. All have experienced extended losing streaks that have pushed their five-year returns into the red zone.