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Wealth Management: Year-End Planning

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One of the “must dos” for any serious investor is to make sure your investment house is in order as year-end quickly approaches.

Ensuring that you have the best technology is an important way to do that, and I have found through years of experience with different custodians that Fidelity has always been the industry’s technology leader (this is not a paid endorsement, just the truth learned from my experience).

Fidelity’s technology leadership began in its earliest days, pushed on by former Chairman Ned Johnson’s passion. I recently wrote about Johnson’s focus on technology that “He wanted to make sure Fidelity was second to none.”

With the extensive technological tools made available to investors at Fidelity, it is easier to implement the strategies I outline for you here, including year end strategies like tax loss harvesting. Here are some ideas from Fidelity on the subject:

5 tax-loss harvesting considerations

Investment losses could help offset gains and income—and help lower taxes

Key takeaways

  • Investment losses can help you reduce taxes by offsetting gains or income.
  • Even if you don’t currently have any gains, there are benefits to harvesting losses now, since they can be used to offset income or future gains.
  • If you have more capital losses than gains, you can use up to $3,000 a year to offset ordinary income, and carry over the rest to future years.

Losing money is not anyone’s idea of a long-term investment plan, but a well-diversified portfolio will usually contain some investments that have indeed lost value, at least over the short-term. Sometimes an investment that has lost value can still do some good—or at least, not be quite so bad. You can sell stocks, bonds, mutual funds, or other investments that have lost value, to reduce federal taxes on capital gains from winning investments—or you could get a federal tax deduction. It’s called tax-loss harvesting.

The key to an effective tax-loss harvesting strategy is to evaluate what you own and why you own it, identify investments that have lost value, and then consider the sale of some portion of those holdings to offset realized gains, expected future gains, or even income. And do this while being careful not to stray from your target investment mix and diversification strategy. Because evaluating and managing the tax consequences of your investment decisions can be tricky, it’s always a good idea to consult a tax professional.

Here are 5 things to keep in mind as you see how tax-loss harvesting might help you lower your tax bill.

Short-term versus long-term gains and losses

There are 2 types of gains and losses: short-term and long-term. Short-term capital gains and losses are those realized from the sale of investments that you have owned for 1 year or less. Long-term capital gains and losses are realized after selling investments held longer than 1 year. The key difference between short- and long-term gains is the rate at which they are taxed.

Short-term capital gains are taxed at your marginal tax rate on ordinary income. The top marginal federal tax rate on ordinary income is 37%. For 2018, it applies to couples filing jointly with income above $600,000, and single taxpayers with income above $500,000. For those subject to the net investment income tax (NIIT), which is 3.8%, the effective rate can be as high as 40.8%. And with state and local income taxes added in, the rates can be even higher.

Tip: Get your 2018 federal tax ratesOpens in a new window

But for long-term capital gains, the capital-gains tax rate applies, and it’s significantly lower.

When the 3.8% NIIT comes into play, the actual long-term capital-gains tax rate for high earners can be as much as 23.8%.1 The NIIT is also known as the Medicare tax. It was introduced as part of the Affordable Care Act.

For more information, read Viewpoints on Fidelity.com: Medicare taxes and you

If you’re a mutual fund investor, your short- and long-term gains may be in the form of mutual fund distributions. Keep a close eye on your funds’ projected distribution dates for capital gains. Harvested losses can be used to offset these gains.

Find out more on Fidelity.com: Mutual funds and taxes

Harvest losses to maximize your tax savings

When looking for tax-loss selling candidates, consider investments that no longer fit your strategy, have poor prospects for future growth, or can be easily replaced by other investments that fill a similar role in your portfolio.

To enhance your potential tax savings, you should apply as much of your capital loss as possible to short-term gains, because they are usually taxed at a higher marginal rate. So, when you’re looking for tax losses, focusing on short-term losses provides the greatest benefit because they are first used to offset short-term gains.

According to the tax code, short- and long-term losses must be used first to offset gains of the same type. But if your losses of one type exceed your gains of the same type, then you can apply the excess to the other type. For example, if you were to sell a long-term investment at a $15,000 loss but had only $5,000 in long-term gains for the year, you could apply the remaining $10,000 excess to any short-term gains.

The least effective tax-loss harvesting strategy, on the other hand, would be to apply short-term capital losses to long-term capital gains. But, depending on the circumstances, that may still be preferable to paying the long-term capital gains tax.

Focusing on short-term losses can be particularly beneficial for high-income investors. For example, if you’re in the top tax bracket, the difference between short- and long-term gains can be as high as 17 percentage points (40.8% versus 23.8%). The difference can be meaningful for those in lower tax brackets as well. For example, if you’re in the 22% tax bracket—$77,401 to $165,000 for joint filers and $38,701 to $82,500 for singles—the difference between the short- and long-term gains rate is 7 percentage points (22% versus 15%).

Also, keep in mind that realizing a capital loss can be effective even if you didn’t realize capital gains this year, thanks to the capital loss tax deduction and carryover provisions. The tax code allows you to apply up to $3,000 a year in capital losses to reduce ordinary income, which is taxed at the same rate as short-term capital gains. If you still have capital losses after applying them first to capital gains and then to ordinary income, you can carry them forward for use in future years.

Stay diversified, but beware of wash sales

After you have decided which investments to sell to realize losses, you’ll have to determine what new investments, if any, to buy. Be careful, however, not to run afoul of the wash-sale ruleOpens in a new window.

Say you want to buy back the same security you sold, because you believe it has good prospects for future growth or because it would be difficult to find an investment that matches the diversification it provides for your portfolio. The wash-sale rule states that your tax write-off will be disallowed if you buy the same security, a contract or option to buy the security, or a “substantially identical” security, within 30 days before or after the date you sold the loss-generating investment.

One way to avoid a wash sale on an individual stock, while still investing in the industry of the stock you sold at a loss, would be to consider substituting a mutual fund or an exchange-traded fund (ETF) that targets the same industry.

Although some substitutions are clearly allowable, others may come closer to the IRS interpretation of what constitutes a “substantially identical” security. If you’re not sure, you should consult a tax advisor before making the purchase.

Make tax-loss harvesting part of your year-round tax and investing strategies

The best way to maximize the value of tax-loss harvesting is to incorporate it into your year-round tax planning and investing strategy. Tax-loss harvesting and portfolio rebalancing are a natural fit. In addition to keeping your portfolio aligned with your goals, a periodic rebalancing provides an opportunity to reexamine lagging investments that could be candidates for tax-loss harvesting.

Select the most advantageous cost basis method

Finally, take a look at how the cost basis on your investments is calculated. Cost basis is simply the price you paid for a security, plus any brokerage costs or commissions. If you have acquired multiple lots of the same security over time, either through new purchases or dividend reinvestments, your cost basis can be calculated either as a per-share average of all the purchases (the average-cost method) or by keeping track of the actual-cost of each lot of shares (the actual-cost method). For tax-loss harvesting, the actual-cost method has the advantage of enabling you to designate specific, higher-cost shares to sell, thus increasing the amount of the realized loss. Learn more about capital gains and cost basis.

Don’t undermine investment goals

Remember this saying: Don’t let the tax tail wag the investment dog. If you choose to implement tax-loss harvesting, be sure to keep in mind that tax savings should not undermine your investing goals. Ultimately, a balanced strategy and frequent reevaluation to ensure that your investments are in line with your objectives is the smart approach.

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E.J. Smith - Your Survival Guy

E.J. Smith is Founder of YourSurvivalGuy.com, Managing Director at Richard C. Young & Co., Ltd., a Managing Editor of Richardcyoung.com, and Editor-in-Chief of Youngresearch.com. His focus at all times is on preparing clients and readers for “Times Like These.” E.J. graduated from Babson College in Wellesley, Massachusetts, with a B.S. in finance and investments. In 1995, E.J. began his investment career at Fidelity Investments in Boston before joining Richard C. Young & Co., Ltd. in 1998. E.J. has trained at Sig Sauer Academy in Epping, NH. His first drum set was a 5-piece Slingerland with Zilldjians. He grew-up worshiping Neil Peart (RIP) of the band Rush, and loves the song Tom Sawyer—the name of his family’s boat, a Grady-White Canyon 306. He grew up in Mattapoisett, MA, an idyllic small town on the water near Cape Cod. He spends time in Newport, RI and Bartlett, NH—both as far away from Wall Street as one could mentally get. The Newport office is on a quiet, tree lined street not far from the harbor and the log cabin in Bartlett, NH, the “Live Free or Die” state, sits on the edge of the White Mountain National Forest. He enjoys spending time in Key West and Paris. Please get in touch with E.J. at ejsmith@yoursurvivalguy.com