Tax loss harvesting can be a valuable strategy to boost after tax returns in taxable accounts. Taxes can erode the value of a portfolio, so that actual returns are significantly lower than market returns. This is true even for an investor able to track the market’s returns perfectly. This can impact all investors, but it especially impacts those in higher tax brackets. Over time, taxes can be a material expense for investors and meaningfully reduce retirement savings.
Tax loss harvesting enables an investor to eliminate or offset capital gains with capital losses. Tax loss harvesting has been a regular component of wealthier investors’ strategies for some time; more recently, however, algorithmic investing has made it possible to implement the strategy even across small accounts. Tax loss harvesting does not require an active investment style or frequent trading. It can be valuable even to an investor pursuing a fundamental buy and hold strategy, with periodic rebalancing, such as with FutureAdvisor’s Premium product. Under tax loss harvesting, while losses are realized to provide tax benefits, the portfolio itself remains similarly invested by holding equivalent positions in similar but alternative securities. As such, if implemented correctly, tax loss harvesting does not necessarily materially impact a portfolio’s tracking error; it simply increases tax efficiency.
The Principal Of Tax Deferral
For most investors, tax loss harvesting is a process of deferring taxes until a future date. The time value of money and inflation both prove that paying for something later is preferable to paying sooner. Tax loss harvesting is somewhat like receiving a loan from the IRS, on which you earn money over time. In addition, many people will see their tax bracket fall once in retirement and drawing down on savings - in this scenario, tax loss harvesting may also reduce the tax burden in absolute terms, in addition to the inflation benefit.
How Tax Loss Harvesting Works
The easiest way to understand the technique’s basic principle is to look at a simple example.
Let's say your portfolio consists of $50,000 invested in ETF X. Then, in a down year, the value of that holding decreases to $45,000. Most investors in this situation would do nothing. An investor implementing tax loss harvesting, on the other hand, would sell the $45,000 holding in ETF X and invest it instead in a similar but not substantially identical fund. In doing so, this investor has 'harvested' the $5,000 loss for tax purposes, though in reality little actually changed - he or she still owns $45,000 of a mutual fund in that asset class, just as if no action was taken. (Note that the investor must be careful not to buy back ETF X within 31 days, to comply with the IRS’s wash sale rule).
Now, because you have booked the $5,000 capital loss, at tax time, you may net this loss against capital gains elsewhere in your portfolio, thereby reducing the amount of capital gains tax you owe in a year when your portfolio earns a net profit. In a year when your capital losses outweigh gains, the IRS allows you to apply up to $3,000 in losses against your other income, and to carry over the remaining losses to offset income in future years.
Challenges Of Implementing Tax Loss Harvesting
Tax loss harvesting requires diligent tracking of tax lots across a portfolio, as well as monitoring market movements, since opportunities for tax loss harvesting can occur at any time given volatile markets. As such, looking for tax loss harvesting opportunities every few months will be less effective than monitoring for opportunities every day. The value of digital advisory services such as FutureAdvisor is apparent here, given their unique ability to save investors time and effort. An algorithm that can monitor for opportunities whenever markets are open and that understands the optimization process can effectively implement the principles of tax loss harvesting. Note that tax loss harvesting is not relevant for tax-deferred accounts including IRAs and 401(k)s.
Rules Related To Tax Loss Harvesting
Tax loss harvesting is a technique that wealthy investors frequently use and if done correctly, is consistent with IRS guidelines and perfectly legal. Two key things to avoid are (1) a “wash sale,” in which the same investment is repurchased within 30 days of being sold, and (2) the purchase of an investment that is “substantially identical” to the investment being sold. Either of these errors would invalidate any potential gains from tax loss harvesting.
How Daily Analysis Increases Opportunities For Tax Loss Harvesting Significantly
Analyzing S&P 500 returns from 1950 to the present shows that, assuming one’s portfolio is rebalanced or has new money deposited every 60 trading days, the opportunity for tax loss harvesting is far greater with daily analysis. Based on our back-testing, there have been only 15 opportunities for tax-loss harvesting since 1950; however, with daily analysis there have been opportunities each year, and often multiple per year. The broader the interval over which data is analyzed, the more likely the underlying index is to have risen in price. By analyzing data on a more frequent basis, one is more likely to observe price declines. This result is a function of the general rise in equity prices historically - the S&P is more likely to decline over a shorter period (a day) than a longer period (a year).
Other Factors That Impact Tax Loss Harvesting
Though time interval is an important variable, tax loss harvesting is also impacted by the number of assets in the portfolio, with opportunities rising as the number of distinct assets increases. In addition, opportunities are more common in bear markets and for less seasoned portfolios given that prices have historically trended upwards for the assets included in FutureAdvisor portfolios.
It's important to consider the impact of taxes in potentially eroding the value of your savings. Tax loss harvesting is a method of tax deferral, which can increase returns. Since algorithms can evaluate opportunities on a daily basis, this method is more beneficial than manual analysis, which is either extremely time consuming, less effective, or both. The gains from effective daily tax loss harvesting can be significant, especially for those with large taxable account balances or in high tax brackets.