Tax planning throughout the year can be the most effective way to increase aftertax returns.
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
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
Tax-loss harvesting can be used with stock portfolios, also. For example, say you bought Microsoft
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
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.
Timothy Strauts is an ETF analyst with Morningstar.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, 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.