TAX LOSS HARVESTING
Tax loss harvesting is a sophisticated wealth management technique that aims to reduce your tax burden to increase your portfolio's after-tax performance.
What is tax loss harvesting?
Imagine that you invested $100,000 into the S&P 500 through an ETF, and then the market drops by 10%, bringing the value of your investment down to $90,000. If you sold your S&P 500 ETF and then reinvested the remaining $90,000 back into the market, you would have locked in an investment loss of $10,000, according to the IRS, even though from an investment standpoint, your exposure to the S&P 500 hasn't changed.
However, this $10,000 loss could be used to offset your taxable income, which would lead to a smaller tax bill or a larger tax refund. And since you kept your exposure to the market constant, you haven't affected your long-term investment strategy.
A mathematical example of tax loss harvesting
Consider another example, where you begin with $100,000 but the market goes up 8% and you receive 2% in dividends, bringing your total return to 10%. You would then have gone to $110,000 with an $8,000 gain from the market and a $2,000 gain from dividends.
For the sake of simplicity, assume you have a 40% marginal tax rate, the highest in the US.
After your yearly taxes, your investment account would have an $8,000 unrealized gain from the market going up, but only a $1,200 gain from the dividends. This is because your dividend income will be taxed alongside your ordinary income, which means that you'll keep $1,200 (60%) and pay $800 (40%) in taxes. Your total gain would then be $9,200 - or a 9.2% gain on your $100,000.
However, if you had harvested your $10,000 loss in the original example when your account dropped 10%, you would have a $4,000 tax loss (based on your 40% tax rate) to offset your future tax liabilities. In essence, this is another 4% gain on the account. This would result in a $9,200 + $4,000 benefit, equal to $13,200, essentially increasing your net after-tax return from 9.2% to 13.2%
There must be limitations though
There are a few limitations and regulations that govern your ability to do this though. Namely:
Wash Sale Rule
The IRS won't let you simply sell and then re-buy an asset, just so you can pay less in taxes. When you file your taxes, the IRS will look for this (Section D of the 1040 tax form) to see if the asset you sold and the asset you bought are "substantially identical." And if the two assets are substantially identical, and there is less than 30 days between the selling and the buying, the wash sale rule will come into effect and cancel out the tax benefits.
However, two assets can be very similar and exhibit a high correlation to each other without being deemed 'substantially identical.' For example, when you sold your S&P 500 ETF, maybe you would then buy a Dow Jones ETF to replace it. The two would exhibit virtually the same characteristics, but would not be identical. Then, you could hold the Dow Jones ETF for 30 days and then sell it to buy back the original S&P 500 ETF, and as long as trading costs weren't prohibitively high, you would have locked in your tax loss and maintained a similar exposure throughout the process.
Taxable Income Limits
There are limits to using this to reduce your taxable income, which are currently set at $3,000 per year - or $1,500 if married and filing separately. However, this strategy is most often effective when used to lower the taxable gains on other investments in a portfolio.
Growing Portfolio Limits
Tax loss harvesting is most effective in the early days of a portfolio because over time, the portfolio will most likely grow and it will be harder to lock in a loss. Still though, it makes sense to lock in those tax losses early in the portfolio so that they can be used to offset future gains when they are realized.
Transaction and Administration Costs
The benefit of harvesting the tax loss needs to outweigh the costs of executing the trades. In the previous example of selling the S&P 500 ETF, buying the Dow Jones ETF, and then re-buying the S&P 500 ETF after 30 days, if the costs for executing those trades outweighed the tax benefit, the strategy would not make sense. Therefore, an account must either be large enough that the tax benefit can outweigh the costs of the strategy for this to be feasible or an alternative tax loss harvesting strategy must be used.
Our view on tax loss harvesting
Tax loss harvesting is a great way for an investment manager to add value to their clients portfolios, and it is something that most individual investors neglect to do because of the complexity and attention required. Additionally, while the examples given here are quite simplistic, there are a wider range of concerns that must be taken into consideration before implementing a tax loss harvesting strategy.
However, if tax loss harvesting is done properly, an investment manager can generate an additional after-tax return high enough to cover - or greatly discount - their own fees, while taking on no additional risk for the client. This is an amazing deal for both the client and the advisor.
At Bisonwood, we place a lot of emphasis on helping our clients to avoid or defer taxes, when possible, through tax loss harvesting and tax-efficient investing because we feel it is one of the most important ways an investment manager can add value.