Tax & Estate Planning
6 MIN ARTICLE
There are very few ways to put a positive spin on market volatility and net loss for investors. But one option that may provide some relief is tax loss harvesting — selling one investment at a loss to offset gains on the sale of another, thereby reducing the tax impact. While no replacement for investment performance, harvesting can make losses easier to accept for investors facing, in some cases, tax rates of more than 23% on long-term capital gains and as much as 37% for gains on short-term holdings for those in the highest federal tax bracket.
Taxes can also be a drag on investment performance. Tax loss harvesting offers an opportunity to add efficiency to an investment portfolio, if you replace the investment with one that’s higher quality, has a lower expense ratio or is more tax efficient — or a combination of the three. Indeed, the benefits of tax loss harvesting can be even greater if there is a chance that gains in the future will be taxed at a lower rate than the losses are today.
“The end of the year is always a good time to look back and assess potential tax liability,” says Leslie Geller, senior wealth strategist at Capital Group. “But at any time of year, if you have or are expecting a large capital gain, you might look to an investment portfolio to see if there are losses to harvest to help mitigate them. Tax loss harvesting can be a great strategy if it makes sense in terms of the client’s overall financial picture.”
Geller recommends careful consideration of the strategy before making a move. By selling an asset at a loss, an investor misses out on future potential gains. Furthermore, the timing of loss harvesting can be tricky, and finding quality replacement assets is key. If you are considering tax loss harvesting for your clients, here are a few things to know.
Tax loss harvesting basics
As a strategy, tax loss harvesting is pretty straightforward: You sell an investment that has lost value, reinvest the proceeds, and use the capital loss to offset capital gains on another investment (today or in the future). But some complex details can make all the difference in the strategy’s success.
For example, there’s a pecking order. Long-term losses must first be applied to long-term capital gains before they can be applied to short-term gains, and vice versa. If an investor’s losses exceed capital gains at the end of the year, the losses can be applied to offset up to $3,000 of ordinary income tax. Even if investors have no gains to offset this year, or have losses greater than current gains, today’s taxable losses can be carried forward to reduce taxes in the future. (To be sure, the strategy works best when there are gains to realize in the same year.)
Then there is the waiting period. Tax loss harvesting can be used on different types of investments, from individual equity securities to mutual funds and exchange traded funds (ETFs). If you sell this type of investment at a loss, however, you may not buy the same (or a “substantially identical”) investment back within 30 days. Under the Internal Revenue Service’s wash-sale rule, there would be no capital loss if the same security is purchased within 30 days before or 30 days after the sale. Interestingly, the wash-sale rule does not apply to cryptocurrency investments, which can also be harvested for losses.
When it comes to the market, 30 days can see significant movement in prices. If you simply wait it out with cash, you risk missing the best days in the market, which can have an impact on returns. And missing even a handful of days in the market can make a difference. For example, consider a hypothetical $1,000 investment in the U.S. stock market, as measured by the S&P 500 Index, from 2012 to 2021. If you remained invested over the entire period, the value of the investment (excluding dividends) would have grown to $3,790. But if you exclude the best noncontiguous 30 days during that period, the investment value would be $1,243, or 67% in missed value.
Optimizing your replacement investments
While some portfolio managers might hold a replacement investment just long enough for the wash-sale period to end before repurchasing the initial investment, harvesting provides an opportunity to consider other options to replace that investment in favor of something entirely new. Selecting those replacement investments — for the short and the long term — can be key to the strategy’s success.
For example, a strategic investment swap may help in:
- Shifting away from individual or concentrated holdings in favor of mutual funds or ETFs to increase portfolio diversification
- Moving from investment vehicles that are less focused on tax efficiency to those that are more tax efficient
- Reducing passive index funds at the core of portfolios in favor of active core holdings
- Lowering investment expenses
While expense ratios are important, taxes can be even more of a drag on performance returns. If you compare the average net expense ratios from Morningstar’s universe of investment products, including mutual funds, index funds and ETFs to their tax cost ratios (which Morningstar uses to measure how much the annualized return is reduced by taxes) it’s clear that taxes have more of an impact on long-term gains than fees.
Tax drag compared to expense ratio
Mutual funds and ETFs that hold similar (or many of the same) assets are not considered substantially identical, which makes it easy to swap one investment for another during the wash-sale period and beyond, without significantly changing the portfolio allocation or profile. With an increasing number of ETFs offering similar asset profiles as diversified mutual funds, with both passive (which aim to track the risk/return profile of an index and rebalance on the same schedule as their underlying index) and actively managed options, more advisors are considering ETFs as one solution for reinvesting harvested positions in taxable portfolios.
ETFs for tax loss harvesting
Along with being generally lower cost investments, ETFs tend to be tax efficient, because investors buy and sell them in a secondary market, like a stock exchange. This helps insulate ETFs from the trading activity of individual investors. Investor redemptions from ETFs do not generally create taxable events for remaining shareholders. This can be an important source of tax efficiency, and make a difference in returns over the long term.
In 2021, just 8.7% of equity ETFs paid out capital gains, according to Morningstar* — mostly those that hold derivatives (which tend to be less tax efficient) and/or trade frequently, meaning they have a high turnover rate. However, even active ETFs can be more tax efficient than other actively managed investments.
Actively managed ETFs can offer the oversight of experienced professionals, helping to manage downside risk and volatility. As with any actively managed investment, it’s important to consider the manager’s approach, transparency, track record and consistency, along with taxes and fees.
ETFs are not completely without tax drag, however. The IRS taxes dividends and interest payments on ETFs as ordinary income, just as they would income from the underlying stocks and bonds. And capital gains are realized when you sell an ETF, just as with any other type of investment.
To harvest or not to harvest?
“While providing more precision around tax planning can be an effective way to demonstrate your value to clients,” says Geller, tax-loss harvesting may not be right for every investor. “You are effectively just deferring your gain.” Kicking that can down the road can be the best tax solution in some cases. But there are other ways to reduce your tax bill, including charitable giving, Geller says.
But in cases where loss-harvesting does make sense, it provides an opportunity to rethink the position. ETFs are worth considering among other replacement assets to help improve the efficiency of the overall portfolio.
Tax & Estate Planning
Tax & Estate Planning
*Source: Morningstar Direct, data as of 1/12/22 for the year ended 12/31/21.
The market indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index.
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