If you are new to this tax game, there is time honored tradition of selling some under-performing stocks – let’s just call them losers – to offset the capital gains of some winning stocks that were sold during the year.
Here’s the fast breaking update on that: It’s still a good idea.
In this world of mutual funds, it is even a better idea. Here’s why. Mutual funds are a collection of stocks managed by a portfolio manager with a strategy in mind. The strategy may be to mimic the S&P 500 index, or to invest in technology companies or the energy sector. Whatever it may be, the portfolio manager has a goal in mind and buys and sells securities consistent with his strategy. He usually will sell securities when he believes the stock is overpriced. That will generate a capital gain, and you will be required to pay taxes on those capital gains. Keep in mind, YOU sold nothing. It was your portfolio manager that did the selling. YOU probably were never even aware of the activity taking place within the fund that you own. But those underlying securities generated a tax event for you.
So that’s why even if you think you did no selling, the mutual fund that you own did. And they did it a lot.
To counter your capital gains that you know about (because you sold stocks) and those that you don’t (because you own a mutual fund and have no idea what the heck your fund manager is doing) selling your losers at the end of the year is an excellent way to offset capital gains with capital losses.
So what happens if you sell so many losers that it far exceeds the offset of your capital gains this year? You can carry over $75,000 of capital losses and use them next year…and beyond. They don’t expire. The great thing about carrying capital losses over to the next year is that they can offset both long term gains and short term gains even if you generated only long term losses (for example). They can even offset up to $3,000 in ordinary income each year the capital losses are carried forward.
Let me get on a soapbox for a minute. I do not believe you should ever buy and sell stocks because of tax advantages or disadvantages. Those decisions need to be driven by your financial goals and thoughtful planning. However, if you really want to dump a loser, these tax benefits can ease some of the sting.
One word of caution. Don’t try to game the system by selling a loser for the capital loss and then buying it back the next day because you like the stock. It won’t work. You have to wait 30 days to repurchase the stock or it is not a capital loss.