FA Playbook

This strategy can help investors save on taxes — if it's done right

Key Points
  • Tax-loss harvesting is the act of realizing losses in a brokerage account to offset capital gains. Leftover losses can offset up to $3,000 of ordinary income in a year.
  • A recent academic paper found that using a tax-loss harvesting strategy from 1926 to 2018 would have yielded an average of 51 basis points per year for people in a 35% marginal tax bracket.
  • This strategy comes with its share of caveats.
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Market volatility can turn into a tax-savings play for savvy advisors and their clients — as long as they do it right.

Tax-loss harvesting is a strategy in which investors deliberately incur losses in a taxable account by selling off investments that have fallen in value.

By doing so, investors can offset capital gains from appreciated assets that they've sold.

"If we had big year for equities and we're taking a gain, can we free up some losses to offset it?" asked Michael Landsberg, CPA and member of the American Institute of CPAs' Personal Financial Planning Executive Committee.

Just be aware that this strategy isn't right for everyone. It can come with its share of trip-ups.

"The main consideration is that tax-loss harvesting isn't the end-all, be-all solution for everyone," Landsberg said.

How it works

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Falling markets present investors with potential losses, provided they've sold some of their assets during the downturn.

If the investor takes the loss by the end of the year, she can use it to offset capital gains realized elsewhere within the portfolio. In the event the losses are greater than the gains, that investor can apply up to $3,000 a year in losses to offset ordinary income.

To maintain the portfolio's allocation, the investor can buy a similar asset to replace the one sold, provided she adheres to the wash-sale rule.

If it goes beyond a certain threshold, it leads to concerns around churning the portfolio, generating trading fees and getting the overall portfolio out of wack.
Michael Landsberg
American Institute of CPAs' Personal Financial Planning Executive Committee

That means that if you sell a security at a loss and buy the same or similar security within 30 days before or after the sale, the IRS won't allow you to claim the loss on your tax return.

Tread carefully. Even if you sell the dogs in your taxable accounts, you can still violate the wash-sale rule if you buy or sell a similar investment in your retirement accounts.

Bear in mind that tax-loss harvesting doesn't save taxes permanently. Rather, it defers them.

That's because at some point, you'll likely sell the asset you bought to replace your losing position — and you'll owe taxes on it.

Finally, investors and advisors should be cognizant of the applicable tax rates. They're key in determining how much you owe or how much you save from selling losing positions.

If you sell a security you've held for less than a year, you're recording either a short term-gain or a short-term loss. Short-term gains are taxed at the same rate as ordinary income: up to a top rate of 37%.

If you've held a security for more than a year and you sell it, you book either a long-term capital gain or a loss. Long-term capital gains are subject to a maximum of 20%.

Defining tax alpha

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Quantifying the benefit of tax-loss harvesting — that so-called tax-alpha — is where things can get tricky.

A recent academic paper modeled out a tax-loss harvesting strategy using a portfolio of the 500 largest securities by market capitalization from July 1926 to June 2018, breaking down that length of time into four 23-year periods.

In all, tax-loss harvesting yielded an average benefit of 51 basis points each year, assuming an investor had a marginal tax rate of 35%.

However, this 0.51% boost was anything but steady. Over time, the tax alpha was as low as 0.26% or as high as 0.88% per year, meaning there was a lot of variability depending on market performance.

"The returns for the strategy are period-specific: The best time to harvest the losses is when stocks are way down," said Terence C. Burnham, associate professor of finance at Chapman University and co-author of the paper.

"The losses do me no good if I have no gains," he said. "The present value of the loss is lower if it's going to be recognized five or seven years out."

Knowing your caveats

CAPTRUST:  Tax losses shouldn't drive your investment decisions
CAPTRUST: Tax losses shouldn't drive your investment decisions

Tax-loss harvesting shouldn't be viewed in isolation, but rather as one part of a long-term comprehensive strategy, advisors said.

"For me, it's less about reducing taxes at all costs in the present," said Bill Sweet, certified financial planner and CFO at Ritholtz Wealth Management in New York.

"For more clients, it's about being efficient with income taxes and how it might be more efficient to realize gains in the present," he said.

Here are some questions to address as you evaluate whether tax-loss harvesting might make sense.

• What's your client's tax rate? Got short-term capital gains? Those are taxed at the same rate as ordinary income, which can be as high as 37%. Short-term capital losses can help offset them.

"In general, the higher the bracket, the more beneficial it is," said Eric Bronnenkant, head of tax at Betterment.

• How will tax-loss harvesting affect diversification? Think about how this activity might affect how your portfolio is allocated.

Portfolios that aren't sufficiently diversified may be heavily concentrated in any one position and subject to sharp swings in value.

• What are the fees? Trading costs are generally falling, but excessive trading could generate fees that nibble at the account.

"If it goes beyond a certain threshold, it leads to concerns around churning the portfolio, generating trading fees and getting the overall portfolio out of wack," said Landsberg.

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