Higher capital gains taxes make compelling case for tax-loss harvesting

President Biden’s latest proposal to raise capital gains taxes has some investors worried about what their tax bill will look like going forward. The plan, if passed, would increase the maximum long-term capital gains tax rate from 23.8% to 43.4% for the highest earning Americans, a level not seen in the past 70 years. 

Figure 1: Highest long-term capital gains tax rates, 1954 to 2020

It has also started a conversation about the investment implications of a higher long-term capital gains rate. Public opinion on the matter has been mixed, but the abundance of empirical evidence suggests that there is no reliable relationship between changes in capital gains tax rates and equity market performance. Coupled with the variable nature of the capital gains tax rate through time, it may not be prudent to make broad allocation changes based on the potential for higher capital gains.

Even though we don’t believe that investors should make any changes in their portfolio allocation, one thing is certain: an increase in capital gains tax rates makes the ability to tax-loss harvest more valuable. 

Figure 2: Tax loss harvesting savings for given levels of long-term capital gains tax rates

Consider the following example:

Today, the hypothetical difference in harvested savings between Scenario A and B is $392 ($868 - $476), but if we let the compounding effect of capital markets take hold, the difference may expand. In 20 years, an investor’s tax savings compounding at 6% per year could increase to $2784, or $1,257 higher than at the current rate. The savings derived from tax loss harvesting today, in our opinion, would be worth more by the end of the investment horizon. 

As capital gains tax rates increase, we believe the value of tax-loss harvesting increases for your clients, and as long as capital gains taxes exist, tax-loss harvesting may be a viable strategy to offset capital gains. A customized strategy using investments in individual single securities can improve the ability to systematically capture these harvesting opportunities and may lead to better outcomes for clients.

IMPORTANT: 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.