Third of a four-part series
John Nersesian remembers the $3,000 limit on deducting net capital losses against ordinary income from the year he graduated from Lehigh and began paying taxes. In his interview with me, he pointed to the same dollar limit decades later.
But that limit is only part of his portfolio discussion. Nersesian, the founder of Nersesian Wealth Education, also described how losses can offset capital gains and why investors sometimes need to sell investments that have performed well to restore the portfolio they intended to own.
Below is a transcript of the interview with Nersesian, edited for brevity and clarity.
What can investment losses accomplish at tax time?
John Nersesian: Nobody likes to invest in a losing strategy, but if you have unrealized losses, they can provide an ancillary benefit.
We start first with short-term transactions. We net out our short-term gains and losses. We then move on to our long-term transactions, taking long-term gains against long-term losses for a net long-term position.
The third step is to pull the two together, to take our net short-term transactions against our net long-term transactions. Losses can be used dollar for dollar to offset gains.
If you have additional losses above and beyond, you can use all of $3,000 of any net loss against ordinary income. I have a bone to pick with the IRS. You want to know what it is?
Bob Powell: I do.
Nersesian: I started paying taxes in 1981. I graduated from Lehigh back then. Do you want to guess the maximum amount an individual could take off ordinary income for any of these losses? It was $3,000.
Here we are, 45 years later, and the number is $3,000.
Why review wash-sale rules before harvesting losses?
Nersesian: When an individual does book a loss to offset gains, they’ve got to be aware of this wash-sale rule.
How can market performance change a portfolio’s risk?
Nersesian: I meet with my adviser, and we talk about our intended strategy. Maybe we wrote an investment policy, and we take a look at where we are today.
Maybe my equity portfolio has done really well. Maybe my fixed-income portfolio has done less well. Now the current holdings are out of alignment with my original policy.
There may be a reason to retain the current exposure, or I may want to rebalance. Rebalancing forces us to do what is emotionally difficult but often financially productive.
Related: The year-end RMD trap: Why waiting until late December could cost retirees 25%
Rebalancing requires you to sell what has already appreciated and reallocate those dollars into assets that have performed less well. The biggest benefit is that it avoids drift: an exposure that was never intentionally sought but may subject our clients or our friends to greater downside risk.
Why can rebalancing feel wrong after market losses?
Nersesian: I’ll give an example going back to 2008. An individual started with a million-dollar portfolio allocated across five core strategies: growth stocks, international, fixed income and so on.
By Dec. 31, the portfolio looked very different. It was down in value, but look at the mix and how it drifted. What started as 70-30 stocks to bonds turned out to be 58-42. The equity portion was lower; the fixed-income portion was higher due to market returns.
I don’t know too many people who went to their advisers at the end of the year, after suffering those significant losses, asking their adviser to buy them more equities.
It would have been counterintuitive for that individual to allocate more money to equities, but that’s exactly what rebalancing would have done.
Powell: It’s an inelegant way of saying it, but sometimes people refer to rebalancing as selling your winners and buying your losers.
Nersesian: If anything, the individual probably would have asked to reduce their equity exposure because of the pain they had just endured. Maybe the greatest benefit of a formal rebalancing approach is that it instills discipline in an emotionally charged world.
How can a written investment policy guide decisions?
Powell: It bears repeating: creating an investment policy statement would take the emotion out of this and guide you. We agreed what our allocations should be. That’s our plan, and we stick to it.
Nersesian: There are two important steps. The first is writing that policy statement or plan. The second is adherence to it, utilizing it after it’s been created. That’s what a great adviser can help you with.
Related: The “Gap Year” Roth: Early retirees slash lifetime taxes before RMDs hit
