Capital Loss Carryforwards and Capital Gain Distributions
April 10, 2015
If I look up the definition of Capital Loss Carryover, I get the definition below:
The net amount of capital losses that aren't deductible for the current tax year but can be carried over into future tax years. Net capital losses (total capital losses minus total capital gains) can only be deducted up to a maximum of $3,000 in a given tax year. Any amounts exceeding $3,000 can be put toward offsetting capital gains in the current year or simply deducted in the next year(s).
This definition, while technically accurate, fails to mention a key attribute...you lost money. You may hear it referred to as loss harvesting (as if you're gathering the bounty of the earth). You may hear it as capital loss carryovers, carryforwards, etc. What they all point to is you lost money in the market and let's try and make it sound a little bit better for fear that you might fire your financial advisor and move your money where they harvest less. But I digress.
The first point here is that a carryforward loss, by definition means that you lost money on a stock. And I don't care what anyone tells you - I would rather pay capital gains than harvest losses. Now, I understand that it is inevitable that we will have stocks that perhaps we should not have picked. It's a dog. It's a sick dog of a stock pick. So sell the loss and offset against the gains. And there is something to be said about strategically selling winners and losers to optimize the tax situation.
Now let's shift gears and talk about capital gains distributions. Mutual funds, by law, have to pass out capital gains to its shareholders. So if there's turnover in the portfolio. This means if the fund manager has sold stock at a gain, the mutual fund will distribute capital gains. This event is generally taxable as a long term capital gain. What has happened though is that when the market struggled in 2008 and 2009 and fund managers took it in the shorts, they went to the farm and harvested a bunch of losses. Translation - your mutual fund took a dump. But...these fund managers kept onto the losses and they were able to offset these losses against gains ever since. But the problem now is that I'm seeing many more mutual funds distributing capital gains again. This means the mutual fund companies are out of losses and that the net return on your investment is going to take a haircut, even if the underlying fund performance is the same. Saying again, that the fund can produce an identical return in 2014 and 2015 but since losses are getting absorbed the net return on investment, after considering taxes, is getting worse in 2015.
Now what can you do?
In short - nothing. Little is certain in life save for death and taxes.
Thanks, Josh. What can I really do?
Well - consider mutual funds that are more tax efficient. Look at a statistic called turnover. This refers to how many times over does the portfolio sell itself. A portfolio that has a turnover of 2.1 means that the investments in the portfolio has changed in 2.1 times in a year. Versus a portolio whose turnover is a mere 0.1 means just 10% of the holdings have changed over in a year. The difference typically is an actively managed fund (where a human being tries to outpace a benchmark) versus a passive fund where you're investing in a benchmark itself. Now, I'm not giving you investment advice. I'm just saying that putting two funds together with a similar objective can have dramatically different net results due to the impact of taxation.
Questions? Drop me a line.