Most investors expect to feel the sting of capital gains taxes on earnings at the end of an “up” year. But during the past year, there were many investors who, despite disappointing results, were not spared. The painful truth is that data shows many funds still distributed taxable gains at levels similar to 2014 despite low market returns.
While it is impossible to go back in time, investors can do better starting now and throughout the year, using the volatility currently seen in the markets to harvest losses, and take an active after-tax perspective with their portfolios. Loss harvesting is the practice of selling investments held at a loss. Tax losses can be used to offset capital gains generated by mutual fund holdings, sale of real estate or from the sale of stock.
While many investors wait until year end to harvest losses, it is important to regularly monitor portfolios for harvestable losses. This helps ensure that tax management opportunities are fully captured and banked as they become available, rather than risking that they dissipate before the end of the year.
When harvesting losses, it is important to be aware of potential wash sales. A wash sale is triggered when an asset is sold at a loss and a “substantially identical” security is purchased within 30 days. A wash sale results in the disallowance of the tax loss. Investors hoping to maintain their market exposure while taking advantage of tax losses face the challenge of finding a suitable but substantially different replacement investment. Investors who currently use index funds or ETFs for the core of their portfolio can replace this exposure with an index-based tax-managed separately managed account for additional tax efficiency.
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A tax-managed separate account (SMA) can be designed to seek index returns similar to those of an ETF or mutual fund, but with the added potential benefit of excess realized losses. Unlike mutual funds, SMAs can pass capital losses through to the individual investor on an ongoing basis.