Is there a certain time of year that is best to leave investments unchanged? Is it best to make changes at the beginning or end of the year?
Answers | 1
This is a very interesting question. I don’t think there is a “time of year” to leave things unchanged. In other words, there is no rule of thumb that would suggest that during specific times of the year that it is best to leave your investments unchanged. You can review and make changes at any time of the year. However, you must always consider the tax ramifications of making changes no matter when they are done.
Let’s say you have a gain in an investment and you want to “cash out.” If you sell before December 31st, you will pay capital gains tax on that gain on April 15th (roughly three and a half months later.) If you wait to sell that same investment on or after January 1, then you will defer that capital gains tax until the following April 15th (as its due fifteen and a half months later.)
Having said that, you should ALWAYS look at your investments before December 31st and make the appropriate changes. What are you looking to do before year-end? You should do “tax-loss harvesting.” What exactly is “tax loss harvesting”? Well, you review your investments and determine those that are worth less than what you invested. These can be sold before December 31st and you will capture a “capital loss” for income tax purposes in the current year. The capital losses can be used to offset capital gains recognized earlier in the year and/or you may also use up to $3,000 of these capital losses as a write off against ordinary income. If you have more losses than gains and still have additional losses after you have used the $3,000, then these additional losses are considered a “capital loss carryforward” that can be used in subsequent tax years.
What do you need to watch out for? The wash sale rules for one. If you buy back into the investment you sold to capture the tax loss before the 30-day waiting period, this is deemed a “wash sale” and you lose the tax advantages that you were attempting to capture. Too many people make the mistake of selling an investment before year-end and then buying back into that same investment before the 30-day period is up. Don’t make this mistake.
Another time of year that makes it a little tricky especially when investing using mutual funds is buying into a new fund in the last half of the year and especially if you are buying into a mutual fund in the last quarter of the year. What is the potential problem? You might be purchasing a tax liability. How does this work? First, almost all mutual funds will distribute capital gains at year-end, either in late November or in December. Let’s say that the mutual fund you invested into in October declares that they will distribute a capital gain of $1.00 per share on December 15. If you own shares on this date, you will be required to pay a capital gain based on how many shares you own. If you own 10,000 shares then your capital gain on this investment would be $10,000. This might trigger a federal capital gains tax as high as 20% or $2,000. This isn’t a great result especially since most likely, you didn’t receive the full capital appreciation in your investment (i.e. the gain) that you are being taxed on. What can make matters worse, if the investment that you made in October went down… you will still get taxed as if you made money even though your investment actually lost money. Yes, with mutual funds you could actually get taxed for a gain on an investment even when you actually lost money! This isn’t a concern if you hold the mutual fund in a tax-deferred retirement account.
As you can see your question is actually about the tax consequences of making changes in your investments and not really about the investment changes themselves.
I hope this helps. I would be happy to answer any follow up questions you may have regarding the taxation of any potential investment changes you are contemplating.