How tax-loss harvesting can minimize taxes

Tax-loss harvesting can help advisors reduce their clients’ capital gains taxes each year. They sell losing or underperforming investments to offset gains in other parts of the portfolio. The assets are then replaced with a similar asset to maintain a client’s desired asset allocation.

In short, the process boils down to four steps:

1. Sell a security at a loss

2. Use the loss to offset capital gains

3. Temporarily replace the assets sold with similar assets

4. Transition back to the original asset

Harvesting at the stock-level will generally produce more opportunities than at the fund-level, given the higher range of outcomes for single stocks.. Some estimates suggest that automated tax-loss harvesting at the stock-level can bear as much as 100 basis points in annual tax alpha. 

Advisors should also remember that tax-loss harvesting can offset ordinary income. If an investor harvests more losses than they realized in capital gains for a given year, they can use as much as $3,000 in harvested losses to offset their income. Anything in excess of $3,000 can be carried forward to subsequent years.

Tax-loss harvesting sounds like a win-win situation for investors, but before advisors harvest every loss in their clients’ portfolio, they should consider some of the nuances in doing it effectively. 

Make sure it makes sense for clients: Tax-loss harvesting may not be the right strategy for every client. For instance, it’s not relevant for qualified retirement accounts where taxes are paid on contributions or withdrawals—not capital gains. 

Carry losses forward: Losses that aren’t used right away can be saved and carried to future tax years. So, if an investor doesn’t want or need to use their losses immediately, they can use them to lower their tax liability down the road.

Beware of wash sales: A wash sale is triggered if a security is sold for a loss and repurchased within 30 days of the sale. In the event of a wash sale, the IRS will forbid the investor from declaring a loss. Suppose an investor wants to take advantage of tax-loss harvesting and remain invested. In that case, they’d need to liquidate their positions and find a similar but not “substantially identical” fund or security to reinvest in. 

Think about costs: Although commission-free trading has become the industry standard, there is always an opportunity cost when tax-loss harvesting. For index investors, an aggressive tax-loss harvesting strategy can change how much their portfolio deviates from its benchmark. This tracking error increases the likelihood that a portfolio meaningfully underperforms or outperforms a portfolio without tax-loss harvesting

There are tradeoffs: Harvesting losses today has to be carefully weighed with future asset allocation goals that address an investor's needs, risks, and goals in a tax efficient way.  Harvesting too much too fast can reduce the ability to achieve a clients desired future allocations in a tax efficient way.

Sounds complicated, right? Fortunately, there are some modern investment platforms that do all this automatically, so advisors never have to worry about a wash sale or how to carry losses forward.

It’s always a good time for advisors to incorporate tax-loss harvesting into their investment management. After all, eighty-seven percent of investors believe they will achieve their goals with a tax-efficient financial plan. But besides the obvious need to give clients what they want, the current political environment may call for tax-loss harvesting.

In the past year, Washington has proposed a few legislations that would change what investors owe come April. The first proposal would increase the long-term capital gains tax rate from 23.8% to 43.4%. In this case, investors would derive more savings from tax-loss harvesting than under the current tax rate. 

Exhibit 1: Potential tax savings under the current and proposed capital gains tax rates.

Note: These are hypothetical tax savings that an investor could generate. For illustration purposes only.

The second, more recent, proposal would close a long-standing tax break on ETFs, known as in-kind redemptions or heartbeat trades. Financial institutions apply this sort of strategy to get rid of appreciating assets without creating a taxable event, and in doing so, these savings get passed down to the individual investors. By closing this loophole, many investors may face higher tax bills than they had in the past.

Intelligent and automated tax loss harvesting can be an effective way for advisors to illustrate their value to clients and help the same clients achieve their goals.

Disclosures

The projections or other information provided regarding the likelihood of various investment outcomes and tax savings are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.

Nothing provided in this piece constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments.