Death and taxes, the two things in this world one cannot avoid. And while equities investments rarely force one to deal with the former, the latter is a permanent presence that cannot be dismissed (or at least, it's HIGHLY advisable that it not be). However, the tax system being what it is, there's any number of things that one can do to smooth over the harsh reality that one does not get to keep all of the money made on the market.
One such method is known as tax-loss harvesting. The basic premise is pretty simple, and it can help investors, particularly with young portfolios, avoid paying at least some of the taxes they might otherwise owe. Lets take a hypothetical investor named Nancy. Hello, Nancy. Nancy, at the start of the year, decided that she wanted to invest in a stock.
She did some research and ultimately decides to buy $1,000 in Groupon (GRPN) stock after realizing that all of her friends are putting their money there as well. Well, now Nancy is looking at the $1,000 she plopped down on Groupon and regretting her decision. The company's lost 16 percent since the start of the year and her initial $1,000 investment is now worth of just $840. Her Bank of America (BAC) stock, though, is taking off! It's up 77 percent this year! The gains are so substantial that Nancy is actually starting to worry about how much she's gonna owe in taxes.
So what is Nancy to do? Here's where tax loss harvesting comes in. If Nancy decides that she's no longer high on Groupon, she could just sell the stock. By selling the Groupon stock, she takes a realized loss on the investment. So, when filing her taxes, she can record a loss on her Groupon investment that will reduce the taxes that she owes at the end of the year. Nancy can then take the $840 she just pulled out of Groupon and invest it in a similar stock, say LinkedIn (LNKD) . If LinkedIn then takes off and makes Nancy oodles of money, she can still take the $160 loss on her Groupon shares as a write down on her taxes at the end of the year. If she sells her LinkedIn shares, she can reduce the taxes she pays on that gain. If she holds it longer, she can reduce the taxes she pays on her wages because of the write down.
"Loss harvesting is a terrific benefit," says Joel Dickson of Vanguard Group, "and we urge investors to take Uncle Sam up on it."
Obviously, tax loss harvesting isn't a cure-all. Firstly, it involves taking a loss on your initial investment in a stock or security. Secondly, one has to divest in said security or stock, which can always come back to burn you. If Groupon takes off and doubles in value by December, Nancy is going to be kicking herself. Tax laws also prevent Nancy from reporting the loss if she buys back the same security or stock within 30 days of the sale due to what's called the "wash-sale rule."
However, tax-loss harvesting can be one way that an investor can help ease the sting of losses while also setting themselves up to benefit more from their gains. In his 1998 study on behavioral economics, Berkeley professor Terrance Odean revealed that people were much more likely to hold onto losing investments in hopes that they'll rebound while selling winners to take gains. With tax-loss harvesting, there's one more reason to buck that trend and cut bait before things get worse.
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