A Simple Investing Trick That Can Save You Thousands
Investing wisely is one of the most traveled paths to building wealth.
As in business, investors need to be wary of costs. Money management fees, fund and ETF expense ratios, trading commissions, and, most importantly, tax costs can rob an investor of large portions of investing gains.
Today, I want to relate a very simple investing strategy that can save you thousands of dollars in costs if used correctly. It is one frequently used by the wealthy but can be easily utilized by any individual investor as well. It works especially well with short-term holding strategies like Magic Formula® Investing, the strategy covered by MagicDiligence. And right now is the best time to think about utilizing this "trick" to save you thousands THIS YEAR.
"Harvesting" The Schaff
The "trick" has a name: tax loss harvesting.
What is tax loss harvesting?
This strategy takes advantage of the tax laws in the U.S. (and many other countries). On a tax return, you must list all of your stock sales, and the according gain or loss associated with each. The net amounts are then taxed at either the capital gains rate (for positions held over one year), or at the individual's income tax rate (under one year).
The key phrase is "net amounts". Seeing as the S&P 500 is up over 15% in the past 12 months (and 48% in the past 24 months), chances are that most investors have booked some substantial stock gains this year. That's great! Uncle Sam thinks so too... and he will gladly take his share of those gains in taxes.
Most all investors hold a few positions at a loss. By selling those before the end of the year, it "hides" some of your gains, saving you on your 2014 tax bill.
A Simple Example
For the purposes of this example, let's just assume these figures all represent capital gains taxed at a 20% rate (here's a more detailed breakdown between capital and income tax treatment).
To this point in the year, let's assume we are sitting on a net $10,000 in capital gains from the sale of stocks earlier in the year. If we do nothing, we would have to pay 20% of those gains to Uncle Sam.
$10,000 * .20 = $2,000
Now, let's assume we have a stock (call it "XX") that is held at a loss of $5,000. Examining the facts, we don't feel that the likelihood of XX appreciating substantially by the end of the year is very high, and we don't consider it a core long-term holding. If we sell it now, we can save some dough come April:
($10,000 - $5,000) * .20 = $1,000
We cut our tax bill in half by selling! The only way this would have been the wrong decision is if our position in XX rose by more than $1,000 by the end of the year - probably an unlikely event.
Be Aware Of The Wash Sale
One important thing to be aware of are the so-called "wash sale" rules.
In a nutshell, this rule states that you cannot buy a "substantially similar" asset for at least 30 days after selling one at a loss.
The reasoning behind this is pretty obvious. If you could just sell your losers to get a tax break, and then immediately buy them back at roughly the same price, it would be a no-brainer to book losses whenever possible.
By enforcing a 30-day period, you have to consider whether your stock could potentially appreciate past the tax benefit you would get by selling it.
Now Is A Good Time To Consider Selling
With Q3 earnings reports largely behind us, now is a good time to consider tax loss harvesting for 2014. Stocks move the most around earnings season, so the likelihood of a big move in any position by the end of the year is reduced. Furthermore, any stocks you sell now you can safely buy back come the new year.
Joel Greenblatt and MagicFormulaInvesting.com are not associated in any way with this website. Neither Mr. Greenblatt or MagicFormulaInvesting.com endorse this website's investment opinions, strategy, or products. Investment recommendations on this website are not chosen by Mr. Greenblatt, nor are they based on Mr. Greenblatt's proprietary investment model, and are not chosen by MagicFormulaInvesting.com. Magic Formula® is a registered trademark of MagicFormulaInvesting.com, which has no connection to this website. The information on this website is for informational purposes only and solely represents the views and opinions of the author. No warranty is provided or implied as to the accuracy, completeness, or timeliness of this information. This information may not be construed as investment advice of any kind, nor can it be relied upon as the basis for stock trades. DON'T RELY SOLELY ON THIS WEBSITE'S INFORMATION OR STATISTICS! Please do your own research before buying. Alexander Online Properties LLC, the proprietor of this website, is not responsible in any way for losses or damages resulting from the use of this information. Alexander Online Properties LLC is not a registered investment advisor. All logos are trademarked properties of their respective companies.
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