By Timothy Strauts
In the world of investment product marketing, aftertax return is hardly ever mentioned. Taxes are unpleasant. They vary from person to person, and because they reduce returns, it looks better to quote before-tax figures. Because the goal of every investor is to increase his or her total net assets (a direct result of aftertax returns), tax planning should be an integral part of the investment process. Tax-planning strategies need to be tailored to each person's distinctive situation, and consulting with a qualified tax professional can be helpful. At the end of the day, it is not what you earn, but what you keep.
For the tax-planning novice, you need to start with the basics. The first step in any tax-planning strategy is to check last year's tax return and determine if you have any tax-loss carryforwards, which can be found on Schedule D. Tax-loss carryforwards are realized losses that were not used to offset capital gains. These losses are available to offset gains in future years and up to $3,000 of income per year. While losses are rarely viewed in a positive light, they can be a useful tool for tax planning.
Having losses from prior years can change your investment strategy. For example, let's say you bought the Consumer Discretionary Select Sector SPDR (XLY) on Oct. 1 of last year. By August, you have owned the position for a little over 10 months and are up about 20%. The investment was made as a play on the recovering U.S. economy, and it has worked out well. Recently, you've been watching consumer-spending numbers, and you're concerned that flat or declining spending will hurt the retailers in XLY. Conventional wisdom would say to hold XLY for another two months to take advantage of long-term capital gains rates. But if you're like many people who have tax-loss carryforwards, there is no reason to wait another two months to sell. Because your gain in XLY may be offset by losses from previous years, it doesn't matter if the gain is short term or long term. In this situation, the best decision may be to take a short-term gain today.
It is always helpful to have a pool of losses to offset future gains, and tax-loss harvesting is the best way to build up these losses. The process starts with reviewing your current holdings and looking for unrealized losses. Holdings that are currently trading at a loss are then sold. If the position was meant as a long-term holding, it can be bought back after 30 days. If you buy it back before 30 days, the loss will not be allowed and will be added to your cost basis in the new purchase.
The 30-day wash sale rule can make it hard to keep your portfolio invested according to your asset-allocation plan. Fortunately, there are ways to maintain your investment exposure and book losses for the future. For example, let's assume you bought Vanguard Small Cap ETF (VB) on April 23, 2010. You purchased it as part of a long-term investment plan. Unfortunately, you had bad timing, and you're down about 10% on your initial investment. This is a good opportunity to harvest losses, but to maintain exposure to small cap stocks, you will need to find an alternative. IShares Russell 2000 Index (IWM), which has had 99% correlation to VB over the last three years, is a good substitute. You would sell VB to book the loss and immediately purchase IWM to maintain your small-cap exposure. After 30 days, you could sell IWM and switch back to VB or just keep IWM in your portfolio. This way you have maintained long-term focus but taken advantage of short-term opportunities.
Tax-loss harvesting can be used with stock portfolios, also. For example, say you bought Microsoft (MSFT) on Jan. 1, 2010. Microsoft has had a tough year, but you believe in the long-term fundamentals. You are currently down about 16% and would like to book the tax loss. Once you sell, you cannot buy Microsoft back for 30 days, but you could buy an ETF with similar exposure to the technology sector. Vanguard Information Technology ETF (VGT), which has a 9% weighting in Microsoft, would make a good substitute. The two funds have had an 84% correlation over the last year. This way if Microsoft does well, then it is likely that the technology sector is also doing well. After the 30 days are up, you could sell VGT and buy Microsoft back.
Tax planning often takes place at the end of the year when it is top of mind. By planning throughout the year, you give yourself more flexibility with your investments. A good example of a year when tax-loss harvesting opportunities were available early in the year but reduced at year-end was 2009. By March 9, 2009, the iShares S&P 500 Growth Index (IVV) was down 24% for the year, creating a great tax-harvesting opportunity. Losses booked at these extreme low levels would have been very useful in the months ahead when the markets rebounded dramatically. Investors who fail to follow a proactive tax strategy invariably have limited options at year-end.
Tax-loss harvesting is a helpful tool to increase aftertax returns, but it is of no value if there are no capital gains taxes to offset eventually. Also, making frequent trades will increase your costs, which if done too much, will negate any tax benefit derived. Investors should focus on developing a sound investment plan first and then look at ways to increase after-tax returns through tax-harvesting strategies.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.