A POWERFUL STRATEGY THAT SHOULD BE IMPLEMENTED YEAR-ROUND
As we approach year end, many investors inquire about ways to reduce their tax obligations for the current tax year. Most are focused on leveraging well known tax-saving principles such as maximizing the use of tax-advantaged benefit plans, college education planning through 529 plans, and charitable giving. For investors with taxable brokerage accounts, one strategy that is often overlooked is tax-loss harvesting.
Tax-loss harvesting occurs when an investor sells an investment at a loss to offset current or potential future gains on other investment positions. The result is that you only pay tax on the net amount of those gains/losses from positions sold, thereby lowering, or even eliminating your taxable gain for the year.
The higher your personal income tax bracket, the greater the opportunity is for tax-loss harvesting. A quick recap of current ordinary income tax rates and the corresponding capital gains rates explains this concept: Those earning less than $40,000 as single filers, or $80,000 as joint filers, pay a 0% long-term capital gains tax. Individuals in the top tax bracket, however, pay a 20% long-term capital gains tax, and some investors are subject to an additional 3.8% net investment income tax.
In an effort to be proactive about taxes throughout the year, many advisors helped clients benefit from the sharp market downturn in early 2020 by “realizing” or “booking” losses. This was achieved by selling pre-identified holdings into the market downturn to realize significant tax-losses, and then reinvesting the proceeds in pre-identified similar investments to fit the client’s overall allocation.
From the IRS’s standpoint, these trades are allowable as long as you avoid the wash-sale rule. According to the SEC, a wash sale occurs when you sell or trade securities at a loss and within 30 days before or after the sale you:
- Buy substantially identical securities,
- Acquire substantially identical securities in a fully taxable trade, or
- Acquire a contract or option to buy substantially identical securities.
2020 Demonstrated Year-Round Nature
Before the pandemic, many investors, or even professional advisors, may have thought that loss and gain harvesting should be executed at year end when one understands which elements of the portfolio are up or down, and the overall tax picture for the calendar year is clearer. For many investors and advisors alike, this approach is a mistake, and we can use 2020 to highlight its potential shortcomings.
In 2020, if an investor waited until the fourth quarter to harvest gains and losses, they would have missed a tremendous opportunity to enjoy large tax losses since most broad-based equity investments increased significantly by year end. The opportunity to enjoy this “win-win” had come and gone by mid-2020. At one point in late March, the S&P 500 was down over 34% year-to-date. By year end, the S&P 500 rested well above a positive 10% return. If you waited until year end to realize losses, then you missed out on the potential to deploy this strategy.
An added benefit of a portfolio that is properly diversified across various asset classes is that the securities don’t always move in tandem. This divergence of returns among asset classes not only reduces portfolio volatility, but also creates a tax-planning opportunity.
Real-World Case Study
The following case study provides a real-world illustration of tax-loss harvesting in action:
In mid-to-late March 2020, Advisor Firm Alpha made trades in almost all its clients’ taxable accounts, realizing substantial losses. Alpha had an emphasis on the firm’s international equity and emerging market equity actively managed mutual funds, and targeted replacement funds in those asset classes that would avoid any wash-sale issues.
Focusing on one client’s portfolio, the Alpha team:
- Sold all the client’s holdings in an Emerging Markets Equity Fund, valued at $619,000, but initially purchased for this client in late 2014. This transaction realized a total loss of $94,000.
- On the next trading day, the Alpha team purchased $619,000 of a different actively managed Emerging Market Equity fund.
- As of August 15, 2021, that position is up 78% and is valued at $1,095,000.
In this way, the client was in the ideal position – up significantly in that segment of their portfolio yet sitting on an almost six-figure loss for tax purposes. Further, if the client didn’t utilize all the losses in 2020, the net amount will be carried forward for future tax years.
Tax-loss harvesting should be part of every astute investor’s game plan. Of course, one needs to understand the rules to implement these tactics properly, and a professional advisor can be valuable here. As 2020 so aptly demonstrated, tax-loss harvesting is ideally a year-round process, allowing the investor to take advantage of opportunities as they arise.