What is tax-loss harvesting?
Tax-loss harvesting—also called tax harvesting or loss harvesting—is the act of selling an asset that is lower in price than its original purchase price, on an adjusted-cost basis. This difference can be a loss that is harvested and used today or in the future to offset realized gains. Creating this loss is considered a tax asset and may help in deferring the recognition of gains (if you have them) until later periods. Done correctly, this deferral of gain recognition is intended to both increase after-tax returns and help maximize after-tax wealth.
Who might benefit from loss harvesting?
Taxable clients—for whom the goal is to maximize after-tax returns—may stand to gain from successful tax-loss harvesting. For taxable clients, the pre-tax return shown in quarterly performance statements can have little bearing on a client’s ability to achieve their financial goals. It’s the amount after-tax that will ultimately help these investors get to where they are going. Productive tax-loss harvesting could make a big difference in deferring gains and maximizing after-tax returns for taxable investors.
What may prevent investors from harvesting losses?
One of the biggest obstacles to this strategy is often client perception. Investors don’t like hearing they’ve lost money, and the term loss-harvesting requires them to acknowledge an investment loss. In other words, to harvest losses, an investor must first admit they were wrong. So, psychologically, it can be difficult to tax-loss harvest.
- We don’t like to admit that we’re wrong. So instead of selling, we hold onto our losing positions. We do this in the hope they'll recover and the investment will at least be even again.
- This isn’t just a feeling, it’s an established theory known as the disposition effect, which states investors tend to sell assets that have increased in value, while keeping assets that have dropped in value.
Why do investors tend to tax-loss harvest only at the end of the year?
Most investors don’t wake up every morning and say, I can’t wait to tax-loss harvest my portfolio today. People are busy and we tend to procrastinate. When do they tax-loss harvest? Typically, it is an exercise addressed just before the year is over. While this might be easier from a calendar planning perspective, investors may be missing other, more attractive opportunities throughout the year – not just at the end of the year.
How has year-end tax-loss harvesting worked for individuals?
Since 1926, the U.S. stock market, based on the S&P 500 Index, has been positive more than 70% of the time, looking at calendar years. Over the past 70 years, based on FactSet data, in terms of monthly returns:
- November has been the single-best stock market month.
- December has been the third-best stock market month.
In other words – on average - waiting until November and December to perform tax-loss harvesting may be limiting investors to two of the worst tax-loss months.
Click image to enlarge
As the chart above shows, it’s important to actively manage for taxes throughout the course of the year to help ensure steps are taken to improve after-tax returns. It should not be an end-of-year exercise. Moreover, in addition to loss harvesting, there are more active tax-managed strategies available to mitigate the tax drag in investment portfolios. These also can be implemented through the entire year.
When it comes to harvesting tax losses throughout the year, does timing matter?
Yes. Done correctly, tax-loss harvesting takes advantage of market corrections—in a sense turning lemons into lemonade. Consider the 2020 bear market, which started and finished within 30 calendar days, the fastest ever. Advisors need to be ready to act—and to act quickly. As an advisor, you also need a systematic process to understand which clients may benefit.
Let’s look at the last two 15%+ market corrections: in the fourth quarter of 2018 and the first quarter of 2020.
Did the timing of tax-loss harvesting matter? What if tax-loss harvesting was systematic through the partnership with an overlay manager? And what if the overlay manager’s process only looked at valuations on month or quarter end? Let’s look at two different scenarios:
- Loss harvesting at quarter-end
- Loss harvesting at month-end
1. Quarter-end loss harvesting:
Note that in both quarters, the best time to harvest losses (market low) did not coincide with quarter-end dates.
2. Month-end loss harvesting:
For illustrative purposes only.
Note that for month-end dates, again, the best time to harvest losses (market low) was not at the month-end.
It’s easy to see the difference between the market low and the month-end or quarter-end. While no one can call the market bottom during the moment, having a process that looks beyond specific dates widens the opportunity set to achieve better results from loss-harvesting efforts. The illustrated differences show the importance of having a systematic tax-loss harvesting program that is monitored and run constantly, whenever markets are open. We believe the best tax-managed programs have robust, experienced, in-house trading capabilities that are laser-focused on seeking the optimal after-tax returns for investors and are prepared to harvest losses whenever they occur, even if the trading activity falls on Christmas Eve.
Do investors have to be in the top tax bracket for loss harvesting to work?
No. The higher an investor’s tax bracket, the more impactful tax loss harvesting is, but there may still be value in the exercise for those in lower tax brackets. Consider an investor with a marginal tax rate of 24.0% + 3.8% (Net Investment Income Tax) for a top federal rate of 27.8%. If you are able to harvest short-term losses equal to $3,000, this harvested loss could be used to offset against short-term gains for tax bill savings of $834 ($3,000 x 27.8). You would use the investor’s long-term capital gains tax rates accordingly. The higher the tax bracket, the bigger the bang for the buck. But there may be lots of “bang” for those in lower tax brackets.
Is scale an issue when it comes to tax-loss harvesting?
It can be. Advisors don’t only work with one taxable account. The multitude of accounts an advisor manages translates to every investor having a specific starting point. Each investor’s cost basis is unique to them and the advisor needs to be sensitive to each situation. Add in the impact of reinvesting of distributions, client withdrawals, marginal tax rate changes—all for every client across your practice and it gets complicated very quickly.
What other mistakes are common when it comes to loss harvesting?
Other than waiting until year-end, quarter-end or month-end, there are three other typical mistakes advisors can make with do-it-yourself tax-loss harvesting:
- After harvesting the loss, being in cash for 31 days or choosing the wrong replacement security – When you harvest a loss, you are selling a security. What should you do with the cash proceeds from the sale? Some investors choose to hold cash while waiting 31 days before repurchasing the original security to avoid the wash sale rule. In a downward trending market, this may be a fine strategy. But advisors often want to keep the cash proceeds invested in the market—typically in a security with very similar characteristics as the original security. If purchasing a replacement security, make sure it has similar characteristics (such as cap size, style, industry, etc.) as the original holding—but is still substantially different (see #2 below). Also, consider whether the client’s asset allocation needs have changed. If not, avoid introducing any unintended risks or deviations from your policy portfolio via the new security. At 31 days or later, consider reverting back to the original security—if the investment rationale still holds.
- Buying a similar security and having the loss disallowed – When making the sale and purchasing a replacement security, make sure the replacement security is substantially different in character. Some aspects to pay attention to include fund share class, benchmark, security type, etc. The IRS can be very particular in regard to the new security being different in nature than the original purchase. If the securities are too similar, the loss may be disallowed, causing the entire effort to be of no avail.
- Making sure the juice is worth the squeeze (understand the materiality) – This isn’t a process you want to do every time a security goes down in value. Consider the size of the portfolio, magnitude of the downturn and costs related to the trades. If your client is in the top tax bracket, take the amount of loss harvested and multiply by 40.4% for short term gains (37.0% + 3.8% for net investment income). That’s how much you are creating in potential tax savings or a tax credit. Again, this only works if you have current gains in the portfolio or can carry forward into future periods.
If tax-loss harvesting requires so much focus, does it make sense for advisors to simply outsource the effort by using tax-managed funds or model portfolios?
It can, if the right provider and solution are selected. It is important to look at the after-tax return that a solution provides. We believe too many investors and advisors focus on pre-tax performance numbers. For tax-sensitive investors, what really matters is not what their investments earn, but what the investors get to keep, after taxes.