Unintended Consequences for a DIY Investor

For many of us, 2020 brought high and lows. This was true for the stock market too. Across the globe, we saw one of the most rapid declines on record, followed by a broad recovery come year-end. Seemingly unstoppable upward trends attracted many first-time investors. But many of these new traders seemed to forget the wise words of Benjamin Franklin, “in this world nothing can be said to be certain, except death and taxes.” One inexperienced investor in particular faced this harsh reality of his “newfound wealth” when he discovered that he owed $800k on just $45k of profits in 2020.

Yep, you read that correctly! This tax figure may seem preposterous, but it was totally accurate, and this story portrays a prime example of the dangers of investing without fully understanding how capital gains and taxes work together. 

DIY Done Wrong

Morningstar reports that on March 22, an Arizona-based financial planner received an urgent message from a panicked investor who had opened a brokerage account early in 2020. When the investor input his Form 1099-B into the tax filing software, he was shocked to see his tax bill jump to just over $800k as a result of $1.4M in capital gain income. 

How did this happen?

When a security is sold, it is considered to be “realized” and therefore triggers a capital gain or loss which may be short-term or long-term in nature, depending on the length it was held. 

The financial planner dug a little deeper and found that over the course of the last year, this investor had transacted $45M in total trades by executing between ten and 50 trades per day. Margin trading had allowed the investor to triple his initial deposit of $30k for a total of $90k in purchasing power. Roughly $200k to $2M in trading volume a few days a week led to a net profit of $45k at year-end. 

Buying on margin is essentially borrowing money from your broker to purchase stock, using the value of your account as leverage. Although this allows you to buy more shares than you could otherwise afford, it is inherently risky. Margin trading amplifies the performance of your portfolio for better or worse. In the case of “worse,” you can be liable for more money than your initial investment. 

Tricks of the Trade

The investor’s $1.4M in taxable capital gains was a result from the “wash sale” rule, enacted by the IRS to discourage investors from selling a security at a loss simply to claim a tax benefit..

A wash sale occurs when you sell a security at a loss, then turn around and purchase a “substantially identical” security within 30 days before or after the sale occurred. As a result, those losses are disallowed as a deduction for tax purposes on the current-year tax return. This means that your sale is essentially “washed out” and the IRS treats your security as if you had never sold it. The cost basis of the security sold is added to the security you replaced it with. 

This is a common trap that many day traders who are unaware of the rules may fall prey to. Oftentimes, a lack of understanding can cost far more than seeking professional advice for your investments. At Mana, any time we adjust your portfolio, including distributing funds to pay for goals and expenses, we manage those capital gains. We do this by skillfully employing a strategy known as tax loss harvesting. 

Tax loss harvesting is the key to selling securities without creating a big tax bill. The intentional implementation of this strategy limits the recognition of capital gains by reinvesting in “similar” (not “substantially identical”) securities. This allows us to maintain the portfolio’s asset allocation, while preserving anticipated risk and return.  

Planning vs Preparation

Tax preparation is a purely historical process; one where you simply enter the data as it appears on your tax forms. It is the act of reporting with the sole motivation of being compliant with federal and state tax laws. As we saw in the case of this investor, filing season is too late to assess any kind of tax strategy as it relates to your investments.   

Tax planning, on the other hand, is where the real value lies. At Mana, we prioritize goal-centered investing and implement strategies like tax loss harvesting to minimize income tax implications. We set aside time throughout the year to craft advantageous opportunities for your investment needs. These solutions are forward-looking in nature and take into consideration your holistic financial plan, which your taxes play a significant role in.

Intended Consequences of a Financial Planning Professional 

Below is a simplified example to illustrate the topics discussed in this post.

Assume an investor earns income that puts them into the highest capital gains tax category (more than $441,450 if single; $496,600 if married filing jointly). They sold investments and realized long-term capital gains, which are subject to a tax rate of 20%. 

The investor's portfolio gains and losses and trading activity for the year are as follows:

Portfolio

• ETF A: $250,000 unrealized gain, held for 450 days

• ETF B: $130,000 unrealized loss, held for 635 days

• ETF C: $100,000 unrealized loss, held for 125 days

Trading Activity

• ETF E: Sold, realized a gain of $200,000. Fund was held for 380 days

• ETF F: Sold, realized a gain of $150,000. Fund was held for 150 days

Without tax-loss harvesting, the tax liability from this activity is:

With tax-loss harvesting, we can sell ETFs B and C to help offset the gains, and the tax liability would be:

Note: Per the wash-sale rule, the proceeds of the sales may then be reinvested in assets like the ones sold, but we would have to wait at least 30 days before purchasing another asset that is “substantially identical” to the asset that was sold at a loss for tax-loss harvesting purposes. However the beauty in investing in ETFs with an understanding of their risk and return profiles is that you can achieve more efficient results by investing in an ETF whose exposure is similar, but not substantially identical to the asset sold. 

By using a tax-loss harvesting strategy, this investor was able to realize significant tax savings of $63,000. That is why at Mana we use intentional planning to implement these strategies throughout the year, so you are best equipped to minimize your tax liability when it comes time to prepare your tax return. Remember, there’s no such thing as easy money! We always recommend consulting a financial planner before making significant investments or transactions.

Jessica is an Intern at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. Jessica focuses on reviewing tax returns and assessing strategies to ease clients’ tax liability.