Tax Loss Harvesting - What is it?

Who likes to pay lower taxes? Most do and one way to accomplish it is through Tax Loss Harvesting. 

When you use a taxable account to invest there is the added advantage to use the losses that may occur to lower your tax bill. There are three benefits to Tax Loss Harvesting:

1. Tax losses represent an interest-free loan that defers capital gains taxes you would otherwise owe into the distant future, and can even eliminate them entirely when you die.
2. After offsetting realized gains, you can use any remaining tax losses to deduct up to $3,000 from your regular income taxes each year.
3. Any remaining losses are rolled over into the subsequent years, so each year until your losses are used up, you can defer your capital gains and apply up to $3,000 against your income.

Suppose you had invested $10,000 into an ETF in a taxable account and later that year it fell to $7,000. Using tax loss harvesting strategy, the ETF is sold to lock in the $3,000 capital loss. Since you are a long-term investor you probably want to do one of two things:

  1. Buy a similar but not the exact same investment after the selling the ETF for a loss.

    OR

  2. Wait at least 30 days to buy the same ETF again.

If you buy the same investment within 30 days the "wash-sale" rule applies and you will lose the benefits of having a capital loss.

The capital loss is valuable in several ways. Before you pay any capital gains taxes each year, you use your capital losses to offset any capital gains, and pay taxes only if you have more gains than losses. If you have more losses than gains, you can apply up to $3,000 of your remaining capital losses against your regular income. And whatever capital losses are still left over can be carried forward indefinitely into future years. Each year, you get to first apply the carried forward losses against capital gains, and then use any remainder (up to $3,000) to reduce your ordinary income.

Using tax loss harvesting to offset capital gains doesn't actually eliminate the capital gains taxes you would have paid. Instead, it defers those taxes into the future. However, future money is worth less than money today.

Using tax loss harvesting to defer capital gains taxes is like receiving an interest-free loan from the IRS. Also, if you still own the shares when you die, your heirs will receive a stepped-up basis, and you will have gotten the up-front benefit from tax loss harvesting while avoiding the taxes on the back end entirely. Finally, the capital gains you owe in the future will be at the potentially lower capital gains rate, while the benefit you receive today of the $3,000 deduction is at your potentially marginal income tax rate. Remember, tax loss harvesting does not work in 401(k), IRA and other retirement accounts. Only taxable accounts.

Bonds - What are they?

Bonds

By definition:  A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate.

What this means…

A bond is a loan. It's that simple. Instead of you borrowing money from a bank, a company or government is borrowing money from you.

How do bonds work?

Bonds are an important part of an investor's portfolio, typically providing low but relatively stable returns. A bond can be considered a type of "loan". When a government or a corporation needs money, they can either borrow it from the bank, or they can borrow it from willing investors. When borrowing from investors the company will issue a bond in exchange for the money. The amount of money that is borrowed is called the "face value" or the "principal". The bond will promise the investor periodic interest payments (or coupon payments) over a certain time period. Most bonds are considered "fixed income securities" because the coupon payments are a fixed amount. Bonds typically pay these coupon payments annually, semi-annually or quarterly. At the end of the time period (called the maturity date), the investor is paid back the amount that was borrowed (the principal).

What about the Federal Reserve and interest rates?

Like stocks, bonds can be traded in a secondary market. In the secondary market, bonds will have a "price" that is often higher or lower that the principal amount. A major factor that affects the price of a bond is the market interest rate. The US Federal Reserve has a big influence over the market interest rate in the US. When market interest rates rise, the price of the bond falls, and vice versa. However, this only affects investors that actively trade bonds. On the other hand, investors that hold onto bonds until the maturity date are promised the principal amount, and aren't affected by the price of the bond. Unless a company goes bankrupt, no matter what happens with interest rates, an investor will receive that principal amount at the maturity date.

Why do people invest in bonds?

People invest in bonds because they are less risky than stocks, and still provides a relatively stable return. Keep in mind, while stock returns tend to outpace inflation, bond returns are eroded by inflation. Because the coupon payments of the bond tend to be fixed, the payments lose purchasing power as prices rise due to inflation. However, the advantage of bond returns is that they are less risky than stock returns. A company must make their debt payments, before they can declare a profit. Additionally, government bonds are generally considered safer than corporate bonds, since governments are less likely to default on their payments. Hence the coupon payments on your bonds are generally more secure than your stock returns.