When the stock and bond markets melted down last year, many investors learned a painful lesson about tax-loss harvesting: Even when share values drop below their purchase prices, it may not be possible to capture the losses to offset gains.
The ability to lock in losses depends on the cost basis accounting method used in a mutual fund or brokerage account. In many cases individuals don’t select a method and as a result, a default method is used, often limiting the potential to fully benefit from investment losses.
Tax rules allow investors to use realized losses to offset capital gains and cancel taxes owed on the gains. Up to $3,000 in losses can also be used to offset annual income, and any excess losses can be used as offsets in future years. Tax-loss harvesting only works in taxable accounts, not in 401(k)s or other tax-deferred accounts.
But cost basis accounting can be a major snag.
“Most people aren’t aware of this issue and the potential impact in terms of the tax effect. If you think about investing 101, this is investing 401–it’s a detail most people don’t track,” says Joel Dickson, Vanguard’s global head of advice methodology.
Dickson says that more than 80% of Vanguard’s brokerage and mutual fund clients are using a default method for calculating cost bases on investments. By contrast, Vanguard’s advisory clients are shown how to maximize tax-loss harvesting in their portfolios, Dickson says.
Investors can select one of several cost basis accounting approaches when they establish their brokerage or mutual fund account. The most flexible approach that enables investors to maximize the benefits of tax-loss harvesting is referred to as specific share identification.
As the name implies, this method allows investors to choose which shares they want to sell. If your aim is to sell shares that would kick off the biggest loss, you would look for those with the highest cost basis. If you want to give shares to charity, you would want to carve out the shares with the lowest cost basis–that would generate the biggest gain–and therefore, the biggest tax deduction.
Using this method, cost basis is defined as the purchase price of an asset. To determine a gain or value, the cost basis is subtracted from the sale price. In a simple scenario, if you buy a share of stock for $10 and sell for $30, you have a gain of $20. If you sell for $1, you have a loss of $9.
While this approach requires diligent record-keeping, “it allows you to be surgical in pruning your sales and can be most advantageous from a tax perspective,” says Christine Benz, director of personal finance and retirement planning at Morningstar.
For mutual fund investors who don’t select an accounting option, the default method is to assume an average cost basis for all shares. The average is determined by dividing the total amount paid for all shares in a fund by the total number of shares. All shares–no matter what their purchase price–have the same average cost basis.
While a market dip is normally an optimal time for investors to cull losses, “if you use the average default method, it can limit your ability to realize losses,” says Rachel Boyell, director of investment strategy and operations at Cassaday and Company, a McLean, Va., wealth management firm.
For example, say you purchased 100 shares of a mutual fund for $1,500 or $15 per share years ago, then later invested in another 100 shares for $2,500 or $25 per share, your average per-share cost basis would be $20.
If the fund’s share price sinks to $20, you can’t capitalize on the $500 loss on your second batch of shares because you have to assume the average $20 cost basis, which zeros out any losses.
Folks who use the average cost basis accounting in mutual funds can switch to the specific share identification approach only if they haven’t yet sold any fund shares, Benz says. “If you have sold and used the average cost basis in the past, you have to use it going forward.”
For investors in individual stocks and ETFs, the default method for selling shares is referred to as FIFO–first in, first out.
With FIFO, when you sell shares, you must sell the oldest ones first.
“Over a long investment time horizon, FIFO is a relatively inefficient tax selection,” Dickson says.
Consider if you invested in Home Depot for the first time five years ago at $187 per share, and bought subsequent shares at the end of 2021 when the stock price was at $400. When the stock price dropped to $270 in September last year, with the FIFO method you wouldn’t have been able to carve out the shares you purchased for $400 and lock in the $130-per-share loss.
Instead, you would first have to sell your original shares. Rather than realizing a loss, the sale would kick off a gain of $83 per share.
Unlike in a mutual fund, investors can change the election in their brokerage account from FIFO to another method–usually the average or specific share identification–even if they have already used their default method on previous sales.
Benz says individual stock investors should prioritize making a change–either to the average or specific share selection approach. “FIFO is the least advantageous method. Since that’s their default, individual stock investors stand to lose the most by not overriding it,” she says.
While tax minimization is an important goal, before selecting a specific share approach, carefully consider if you will be able to keep up with the record-keeping, Boyell says.
“If you have many purchases and have owned shares for a long time and reinvested dividends from day one, you could potentially have hundreds of positions and to look at which ones to sell could be a laborious process,” she says, adding that when you factor in the value of your time, you may decide the average default method is the best approach.
This article was originally published in Barron’s on June 6, 2023, and was written by Karen Hube. Image courtesy of iStock.
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