Does Tax Loss Harvesting Really Work?
Its about as traditional as putting up your holiday themed decorations, having the holiday office party, and exchanging gifts. For investors, tax loss harvesting has been a December tradition for as long as theyve been an investor, and to say anything negative about it could make you the Wall Street Grinch. As an investor you should always have data to back up your decision. Well look at whether the data supports the stated benefits of tax harvesting. (To learn more, read Tax-Loss Harvesting: Reduce Investment Losses.)
What Is It?
Not too up on this whole tax loss harvesting thing? Lets say in 2011 you were absolutely sure that gold was going to $2,100 so when it hit $1,900 you pulled the trigger on some shares of SPDR Gold Shares (ARCA:GLD), the most popular exchange traded fund (ETF) that tracks the price of gold. Your call hasnt materialized so you youve lost $2,000 on that position. Youre still sure its going to push through the $2,100 level so you would really like to hold on to it, but youve had a good year and you have $8,000 that are subject to capital gains taxes.
Heres your plan. Youre going to take your loss on your GLD position and put the $2,000 against your $8,000 in gains so you only have to pay taxes on $6,000 of capital gains. You know you have to avoid something called a wash-sale rule that doesnt allow you to sell and immediately repurchase GLD so you may put your money to work somewhere else for 30 days and then reinvest in GLD after that. Thats tax loss harvesting. (For related reading, see Selling Losing Securities For A Tax Advantage.)
Trying to beat the system is often a fools game and in the case of tax loss harvesting, that may be true. The Wall Street Journal took on the role of the investing Grinch when they looked at how well tax loss harvesting actually works. They found that it wasnt as much of a gift under the tree that some people think.
Tax expert Kent Smetters is a professor of risk management at the University of Pennsylvanias Wharton School and cites a few of the normal culprits that remain a thorn in the side of investors: inflation and tax rates.(Check out Timeless Ways To Protect Yourself From Inflation.)
Because tax loss harvesting isnt removing your tax liability, youre going to pay the taxes sometime in the future. When you sold your GLD position at a loss, you lowered your entry point, or tax basis by $2,000 for the next position you open.
Later on, presuming your call of $2,100 gold comes to fruition, you now owe that extra $2,000 that you harvested in 2011 and youll pay the taxes on that gain at what could be a higher tax rate and using dollars that are worth less in the future than they are today. All of that, according to Smetters adds up to minuscule savings, if any at all.
The Bottom Line
Smetters analysis doesnt suggest that all tax loss harvesting is ill advised. Investors along with their financial and tax advisers should instead carefully consider and calculate the potential savings involved in this strategy instead of believing conventional wisdom.