The pandemic has done a number on the stock market this year. But for investors with taxable accounts, that damage comes with a silver lining: bountiful opportunities to lower their tax bills.
As every year comes to a close, these individuals and their advisers seek to “harvest” losses of poorly performing stocks and funds to effectively shrink the amount of profits on which they’ll owe capital gains taxes. The 2019 bull market presented few chances for the strategy, and while the coronavirus pandemic has broadly hammered stock portfolios, it also produced losses investors can use to reduce taxes owed on money made from positive trades.
Some investors took advantage of this practice during the massive pandemic-related selloffs in the spring. But with a wave of new coronavirus infections across the country, stalled relief talks in Washington, and presidential election uncertainty, wealth advisers say it’s not too late for “tax loss harvesting,” which tends to be an end-of-year practice.
As investors get a better idea of where they stand tax-wise for the year, “they’re trying to fill in the gaps,” said Jeffrey Herman, a wealth planning strategist at J.P. Morgan Wealth Management. “They’re trying to match those losses or match those gains.”
Erin Hay, a portfolio manager and private wealth adviser at Monument Wealth Management in Alexandria, Va. compared this year to 2008 and 2009, noting that “when the markets are down, it does provide a pretty good opportunity to harvest tax losses and reduce capital gains in any given year, so it’s not a new phenomenon.”
The presidential election serves as another reason to harvest losses, tax and finance professionals said, as the outcome could lead to an increase in capital gains tax and income tax rates.
Ben McGloin, head of advice, planning & fiduciary services at BNY Mellon Wealth Management, said the election and the pandemic is creating uncertainty, which affects short-term and long-term planning around stock portfolios and tax-loss harvesting.
But in the long term, Democrats’ capital gains and income tax proposals are sowing uncertainty in planning for 2021, and beyond. Investors are weighing a tradeoff of minimizing tax exposure this year compared to future years, and they could accelerate capital gains they are already planning to realize, McGloin said.
The prime beneficiaries of the strategy are higher-earning individuals with taxable accounts and lots of taxable income, Hay said.
The top 10% of households by income hold the lion’s share of stock through taxable accounts and retirement accounts, with $1.7 million worth on average, compared to an average of $11,000 for the bottom half of households, according to a study from the Urban-Brookings Tax Policy Center.
Equity strategists at Morgan Stanley, in an October report, flagged a string of stocks with prices that dropped at least 10% between mid-January and the end of the third quarter: Walt Disney Co., General Motors Co., Honeywell International Inc., health insurers Cigna Corp. and Anthem Inc., Hasbro Inc., Medtronic Plc, Wyndham Hotels & Resorts Inc., and Northrop Grumman Corp.
Investors still need to abide by certain rules to avoid harsh penalties from the IRS.
The most common pitfall is what is known as the “wash-sale rule,” which prohibits investors from selling a security at a loss and buying another “substantially identical” within 30 days of that sale.
If an investor breaks the rule, the tax loss is voided by the IRS and is added to the original purchase price of the new stock bought. It is meant to keep investors from selling just to claim a tax benefit, and applies to other brokerage accounts and tax-exempt retirement accounts held by the individual making the sale.
And while not buying the same stock again is straightforward, steering clear of the rule with shares of mutual funds and exchange-traded funds that often follow the same indexes is often not.
Those rules could be a problem for “DIY investors” that aren’t as familiar navigating those waters with popular investment apps like Robinhood, J.P. Morgan’s Herman said.
“Perhaps on the investment side, those people may also not be seeking advice on the accounting side, on the tax side, and do run the risk, because the rules are quite different,” Herman said.