The Markets Are Rallying. How to Make the Most of Them

In the trajectory of the financial landscape since the inception of 2022, where the Federal Reserve initiated a series of interest-rate increases, stocks have nearly obliterated all their losses. Simultaneously, bonds have experienced a rally, although not to the same extent.

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For investors contemplating year-end tax maneuvers, an intriguing scenario has unfolded. Typically, those seeking to capitalize on stock gains explore opportunities to "harvest" losses in other segments of their portfolio to mitigate tax obligations. Traditionally, this did not involve selling bonds or bond funds, as losses were infrequent during the extended period of ultra-low interest rates.

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However, the current scenario presents a departure from this norm, as numerous bond holdings remain in negative territory despite the market's resurgence since mid-October. According to Morningstar Direct, corporate and intermediate core bond funds have incurred a cumulative loss in price of approximately 20% for the three years ending Nov. 30. These losses, though unfortunate, come with a silver lining as they can be utilized to offset taxes on investment gains, particularly when bonds are held in taxable accounts rather than tax-sheltered retirement accounts like IRAs or 401(k)s.

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Karen Veraa, head of iShares' fixed-income strategy in the U.S., emphasizes the significant opportunity for investors to limit taxes and strategically reposition portfolios through tax-loss harvesting in fixed income.

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The mechanics behind this strategy involve selling losers, whether stocks or bonds, to realize a capital loss that can be used to offset taxable gains from selling winners. The tax code allows this offset even if the gains are from different asset classes, meaning losses from bonds can shelter gains from stocks or real estate. Furthermore, if an investor incurs more losses than gains, up to $3,000 of losses can be deducted from ordinary income, offering additional tax relief. Unused losses can also be carried forward for future utilization.

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This strategic use of losses is a tool savvy investors employ to cushion the impact of market downturns and reduce the costs associated with rebalancing portfolios. Given the stock market's rebound in the current year, many significant losers are now situated in bonds.

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Consider a hypothetical scenario where an investor, Martha, wishes to exit a high-fee stock fund but anticipates triggering taxes on $25,000 of gains. However, Martha also possesses a corporate bond fund with $30,000 in current losses. By selling both positions before year-end, the bond losses can offset the tax on stock gains and an additional $3,000 of income, leaving $2,000 of losses for future use.

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For investors wanting to maintain their bond allocation, there's a potential penalty if they repurchase the fund immediately. However, they can navigate this by purchasing a similar fund, holding it for 30 days before selling, and then repurchasing the original holding. While this incurs a cost by likely resetting the cost basis of the bond-fund investment lower at repurchase, it aligns with a principal goal of tax planning: deferral.

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It's crucial to acknowledge the timing aspect of loss harvesting. Losses on investment sales can be carried forward, but they cannot retroactively reduce taxable gains from a prior year. Therefore, investors must be strategic in aligning losses with gains within the same calendar year.

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Karen Veraa suggests using $3,000 as a benchmark for taking losses, as this amount can shelter ordinary income per tax return each year. However, the decision to harvest losses is subjective, with some advisors recommending a loss threshold of at least 5% and $5,000.

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Investors must also navigate the "wash-sale" rule, which penalizes those who repurchase an identical bond or bond fund within 30 days of selling it. To avoid this, investors often switch into similar but not identical holdings for the 30-day period.

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Individual bonds can also be considered for loss harvesting, with the capital loss typically calculated as the difference between the bond's purchase price and its sale price. Special rules apply if the bond was issued with discounts rather than at par value.

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In conclusion, the unique dynamics in the current financial landscape provide investors with a strategic opportunity to leverage losses in bonds for tax planning purposes. Understanding the nuances of tax-loss harvesting and carefully navigating its implementation can yield significant benefits in reducing tax obligations and optimizing portfolio positions.