Tax-loss harvesting is a powerful tool in planning and getting the most from your investments and can even help increase your portfolio returns. The IRS says you can offset capital gains booked each year with an equal amount of losses.
Even better, it allows you to deduct up to $3,000 in income from losses that aren’t offset with gains. Any losses booked beyond that $3,000 limit carry over to offset future years’ gains.
The problem for many investors in planning tax-loss harvesting is that wash-sale rule and the fear that your harvested-stock will rebound in the 30-days you don’t own it.
This is where a little stock research, finding a correlated or similar stock, can fill the gap and help you take advantage of this powerful tax-planning tool.
How Much Can Tax Loss Harvesting Boost Your Returns?
Factoring in the offset on taxes, tax-loss harvesting can add a significant amount to annualized returns.
Claims of the return increase from a tax-loss program at some robo-advisors are as high as 2.7% on an annualized basis while other studies point to a 0.5% increase in returns. Either way, that incremental gain each year can add up big time over 30 years of investing.
Adding a tax-loss increase of just 1% annually to a $100,000 portfolio means an extra $34,785 over three decades of investing.
While the rules around tax-loss harvesting are straight-forward, the planning and what to buy or sell can be a more difficult decision for investors. Let’s look at three steps to set up your tax-loss plan and how to decide which stocks will give you the biggest tax gain while maintaining upside potential.
How To Decide What To Buy And Sell For Tax Loss Harvesting
There are two IRS rules to understand when planning for any tax-loss harvesting. First is that losses and gains must first be applied within the timeframe of either short-term or long-term investments.
This means adding up all your realized capital gains for the year, keeping your short-term and long-term gains separate, then adding up the realized losses within each group.
A powerful step usually missed by most investors is to also add up the potential gains and losses from investments you still hold. Tax-loss harvesting can help you take some of those future taxable gains off the table early by realizing the gain and offsetting it with a loss.
The second IRS rule to remember while tax-loss planning is the wash-sale rule, stating you cannot buy options on a stock or an identical investment within 30-days of the sale.
Of course, stocks of companies that no longer fit with your portfolio strategy or those that don’t look like they’ll rebound are no-brainers for loss harvesting. This is a good time to re-evaluate the upside potential to your losers and ask yourself honestly if you still want to own the shares.
Shares of losing stocks that still have upside potential, ones in which you still want exposure, are a more difficult decision to sell. You can buy back into the shares after the 30-day period expires but may want to maintain exposure for a potential rebound during that time.
Finding Tax-Loss Harvesting Stocks To Fill The Gap
There are two alternatives to consider that will help maintain your upside exposure while taking advantage of tax-loss harvesting.
You can invest more broadly in a sector or industry fund. Even if the fund holds shares of the harvested stock, it’s not considered an identical investment by the IRS and it will give you that macro-level exposure to the theme.
You might also decide to park your money in shares of a competitor within the same industry as the harvested stock. This is appropriate when both companies are suffering from the same industry-level headwinds and losses have been similar at each.
Besides that qualitative idea of positioning in industry ETFs or competitors to maintain your exposure to upside in a harvested stock, you can also look to price correlations to find investments with the potential to track upside returns. Correlations run from -1.0 to 1.0 with the latter indicating the two investments track each other perfectly.
As an example, I took three of this year’s biggest losers in the S&P 500 as tax-loss candidates and looked for funds or peers that could make for good replacements.
General Electric (NYSE: GE) was one of the biggest losers of 2017 and has held on to the title this year with a 60% loss in 2018. Management seems to be making the tough decisions that could lead to a turnaround but hasn’t been able to prove it to the market yet.
Given the company-specific problems at GE, the difficulty of finding a highly-correlated stock isn’t surprising. The Industrial Select Sector SPDR (NYSE: XLI) holds a 3.5% exposure to GE but only a 0.39 correlation. Shares are down by 16.7% this year and trade for 15-times earnings of stocks in the fund.
Curtiss-Wright Corporation (NYSE: CW) is only slightly less correlated with shares of GE though overlaps its business model very closely. The $4.4 billion company is diversified across aerospace, defense and power generation. Shares have fallen 18.6% this year and trade for 17.4-times trailing earnings.
L Brands (NYSE: LB) was once a darling of apparel investors for it strong brands in Victoria’s Secret and Bath & Body Works. Management missteps have caused the shares to plunge 56% this year and the stock now trades for 9.3-times trailing earnings.
Fund alternatives to a harvested stock in some industries are the most appropriate choice to maintain exposure. This is especially true in industries like retail apparel where brand strength is highly important and company-specific. Investing in the industry fund still maintains that macro-level exposure until you can reinvest in the harvested stock to take advantage of a rebounding brand identity.
The SPDR S&P Retail ETF (NYSE: XRT) holds 1.4% of its fund in shares of L Brands and tracks the company shares with a 0.51 correlation. Shares of the fund are down a relatively modest 13.3% this year and trade at 12.4-times earnings of the companies held.
Schlumberger Limited (NYSE: SLB) has led the oil equipment and services industry lower since mid-year and is now down 48% for 2018. OPEC decisions to cut production and support oil prices could put a floor of support in and help drive a rebound for the industry.
The iShares U.S. Oil Equipment & Services ETF (NYSE: IEZ) holds nearly a fifth (17.5%) of its investments in Schlumberger, making it very highly correlated (0.92) with the shares. Energy production in the U.S. is still growing and the fund is an excellent way to benefit from a broader rebound. Shares are down 48% this year and trade at 22-times trailing earnings of companies held.
Halliburton Company (NYSE: HAL) competes in many of the same markets as Schlumberger and tracks the company closely with a 0.74 correlation. The company has been a leader in oil & gas engineering since the 1920s and one of the first to focus on shale. Shares are down 46% this year and trade at an attractive 13.2-times earnings.
Risks To Consider: Replacing a harvested stock with a sector fund or correlated peer still risks missing out on the upside to a company-specific headline though it might drive shares of the fund higher.
Action To Take: Take advantage of tax loss harvesting to reduce your taxes on booked or potential capital gains.
— Joseph Hogue
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Source: Street Authority