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Lemons to Lemonade

Jonathan Clements  |  November 16, 2016

AROUND THIS TIME of year financial advisors and the media start talking about taking tax losses. The notion: You sell underwater investments in your taxable account, and then use those realized capital losses to offset realized capital gains and up to $3,000 in ordinary income.

There’s nothing wrong with taking tax losses, though I think the notion is oversold. Unless you’re an active trader or a really bad investor, you probably won’t have any losses to take. Let’s say you hold a diversified portfolio. Within a few years, all of your investments should be above your cost basis—and, absent a huge bear market, you’ll never again get the chance to take tax losses.

Still, if you do have a losing investment in your taxable account to sell, the math can be impressive—especially if you don’t have any realized capital gains. Let’s say you have a $3,000 loss on your international stock-index fund. You realize the loss. Because you don’t have any realized gains, you can offset the loss against your ordinary income. If you’re in the 25% tax bracket, that would mean $750 in tax savings.

To maintain your foreign stock exposure, you immediately buy another international fund. You can’t buy the fund you just sold, or one that tracks the same market index, or you could run afoul of the so-called wash-sale rule. Instead, you purchase a fund that tracks a different international index. That fund then rebounds, so you make back your $3,000 loss. If you held the fund for more than a year and then sold, your gain would be taxed at the 15% long-term capital gains rate, assuming you’re still in the 25% income-tax bracket. Result: You’d pay $450 in taxes, or $300 less than your earlier tax savings.

Better still, you’d hang on to the fund, so the tax bill is delayed, allowing you to use the money earmarked for Uncle Sam to earn additional gains. Even better, you might bequeath the fund to your kids—at which point the capital-gains tax bill would disappear.

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