AT THE START OF THE pandemic, we picked up a nice chunk of capital losses. I say “nice” because these were intentional. When the market dropped significantly, we realized losses and immediately reinvested the proceeds in other fallen stocks.
What about capital gains? In 2020, some of our mutual funds distributed capital gains, but we didn’t intentionally realize any other gains. Some of our realized losses offset the distributed fund gains. Another $3,000 was applied against ordinary income. But our remaining capital losses were carried over for future years. We intend to put some of these losses to use in 2021, allowing us to harvest more tax-free gains.
Our taxable accounts have a combination of index funds, actively managed funds and individual stocks. Where should we realize gains? One approach would be to simplify our portfolio by selling individual stocks, which include some rather small positions. As we get closer to retirement, having fewer holdings would make managing our investment income and taxes simpler. It would also make the portfolio easier for my wife to manage should I not be around to help.
But I’m not 100% convinced this is the right strategy. Besides being tax-efficient and very low cost, some of the individual stocks are nice dividend payers. As I near retirement, I wonder if this is the right time to remove a source of income. Finally, some of our holdings are undervalued, according to Morningstar. Why sell these now if they may have room to run?
Another approach would be to realize gains in one or more of our actively managed funds. That would slightly improve our overall portfolio’s tax efficiency and slightly reduce our overall fees. None of these funds is highly tax-inefficient, judging by the tax cost ratio provided by Morningstar. But there’s undoubtedly room for improvement. One drawback: If our goal is to use up our tax losses while not ending up with a net realized capital gain, we couldn’t eliminate any of these fund positions entirely if we took capital gains—which means we wouldn’t do anything to simplify our portfolio.
Whatever we decide, we won’t take much action until our funds announce their year-end distributions. At that point, we can subtract those distributions from our carried-over losses, plus $3,000. Then we’ll know what further gains we can realize.
As many readers are no doubt aware, the IRS allows $3,000 in losses to be applied against ordinary income each year. I’ll take care not to realize so much in capital gains that I miss the opportunity to offset that $3,000 in ordinary income. After all, ordinary income tends to be taxed at a higher marginal rate than capital gains.
As I look ahead, I anticipate that at least some of the gains we realize will need to come from the sale of individual stocks. Why? When we sell mutual fund shares, we won’t know the selling price until after the fact. With individual stocks, on the other hand, we can set a limit price and expect to get it. That way, we can match our realized gains more precisely to the amount of our available carried-over losses.
All of this may seem overly complicated. Quite possibly. But in retirement, I know we’re going to be conducting an annual review of where next year’s money is coming from—and whether and how much capital gains and losses should be realized. As complex as all this may sound, I’d better get used to it because I’ll be doing it again.
Finally, as I write this, I can imagine someone recounting the adage about “don’t let the tax tail wag the investment dog.” I agree with that sentiment, but that isn’t my intention. We’d be happy to hold on to everything we currently own. If that weren’t the case, deciding what to sell would be a whole lot easier.
Michael Perry is a former career Army officer and external affairs executive for a Fortune 100 company. In addition to personal finance and investing, his interests include reading, traveling, being outdoors, strength training and coaching, and cocktails. His previous article was An Appreciated Gift.