Short-term market returns are notoriously unpredictable (consistently inconsistent, you could say). When our team at Modera is monitoring our clients’ portfolios, it’s with an eye towards maintaining a strategic mix of stocks, real estate, bonds, and bond diversifiers over the long run. However, short-term market movements can create tax opportunities, and I want to highlight some of the work we do in tax loss harvesting that you may not be aware of.
How is money in my brokerage account taxed?
Interest from bonds (excluding municipal bonds, which are free from federal tax) and dividends from stocks are taxed at ordinary income rates, in the same way as a distribution from your IRA account would be. This is true even when the dividends and interest are reinvested, or the cash is used to purchase additional investments and never leaves your account.
The next primary driver of taxes is growth or loss of your investments through market returns. When you purchase a stock mutual fund or ETF, you become the owner of a very small sliver of multiple companies and are entitled as a shareholder to a stream of future profits. A company’s ‘value’ is reflective of its anticipated growth and the enrichment, in the form of dividends and capital gains, that owners of the stock expect. If you buy $10,000 of stock and over time the value of your investment grows to $15,000, then assuming any dividends have been distributed and not reinvested, the $5k difference in wealth is a capital gain.
Unlike with dividends and interest, capital gains, and their associated tax advantages or tax consequences, are realized only when the position is sold. At that point, a position with growth that has been held for one year or less is taxed at short-term capital gains rates (the same as ordinary income). A position that has been held for longer than a year is taxed at long-term capital gains rates, which are lower than ordinary income rates.
What is tax loss harvesting?
Volatility in the markets can create situations where a stock mutual fund goes down in value and is worth less than it was at the time of purchase. What’s important to note is that when a capital loss is realized, it can offset current and future portfolio gains, as well as current and future income. Short-term losses are deducted against short-term gains, and long-term losses are deducted against long-term gains, and from there the net short-term and long-term performances are netted against each other. Finally, any overall losses can be deducted against ordinary income at the rate of $3k per year if you are filing your taxes as married or single (or $1,500 if married and filing separately). Any losses that you can’t deduct in the current year, because they exceed your total capital gains added with the amount of ordinary income you can offset, are carried forward into future years.
Does tax loss harvesting distort my portfolio?
When it’s done thoughtfully, tax loss harvesting doesn’t cause your portfolio to meaningfully change from its intended mix of stocks, bonds, and bond diversifiers. Your asset allocation, the composition and relative weight of different kinds of assets such as US companies, real estate, and high-quality bonds, is constructed by Modera in light of your goals and expected future expenses. As such, if a chunk of your International stock exposure is sold in order to ‘harvest’ (realize) losses that can offset gains and income, it’s important that International stock is repurchased in order to keep your portfolio at its strategic targets.
Alas, if only it were as easy as re-buying the same mutual fund again! The IRS has a wash-sale rule that prevents an investor from using a loss from a sale in order to reduce their tax burden if a “substantially identical” stock or mutual fund is purchased within 30 days of the sale. So, if you were to sell a position with a loss, and then re-purchase the same mutual fund 15 days later, you wouldn’t be able to use the loss to offset taxes. Simply waiting 31 or more days to repurchase the position may not be the best idea, either. Because market returns are not delivered in a neat, consistent fashion, missing out on 30 days of being invested can result in missing out on significant market gains or movements. However, by purchasing a mutual fund with a similar (but not identical) composition, our clients are able to stay invested and also harvest a capital loss to offset other taxes.
The bottom line
You may have heard us say that portfolios are like bars of soap – the more you handle them, the smaller they get! Needlessly transacting and incurring fees is antithetical to our approach of long-term diversification implemented with low-cost mutual funds and exchange-traded funds. However, tax awareness is embedded in how we operate. When short-term market movements produce portfolio losses, we see the silver lining in the storm clouds, and seek to tax loss harvest where appropriate.
Modera Wealth Management., LLC is an SEC registered investment adviser with places of business in Massachusetts, New Jersey, Georgia, North Carolina and Florida. SEC registration does not imply any level of skill or training. Modera may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration requirements.
For additional information about Modera, including its registration status, fees and services and/or a copy of our Form ADV Disclosure Brochure, please contact us or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). A full description of the firm’s business operations and service offerings is contained in our Disclosure Brochure which appears as Part 2A of Form ADV. Please read the Disclosure Brochure carefully before you invest or send money.
This article is limited to the dissemination of general information about Modera’s investment advisory and financial planning services that is not suitable for everyone. Nothing herein should be interpreted or construed as investment advice nor as legal, tax or accounting advice nor as personalized financial planning, tax planning or wealth management advice. For legal, tax and accounting-related matters, we recommend you seek the advice of a qualified attorney or accountant. This article is not a substitute for personalized investment or financial planning from Modera. There is no guarantee that the views and opinions expressed herein will come to pass, and the information herein should not be considered a solicitation to engage in a particular investment or financial planning strategy. The statements and opinions expressed in this article are subject to change without notice based on changes in the law and other conditions.
Investing in the markets involves gains and losses and may not be suitable for all investors. Information herein is subject to change without notice and should not be considered a solicitation to buy or sell any security or to engage in a particular investment or financial planning strategy. Individual client asset allocations and investment strategies differ based on varying degrees of diversification and other factors. Diversification does not guarantee a profit or guarantee against a loss.