The recent volatility in equity and fixed income markets has led to a proliferation of stories about the benefits of tax-loss harvesting. If you had a nickel for every story out there mentioning “turning lemons into lemonade” or “silver lining of market pullbacks” or “upside of downside markets,” you could likely retire rich. Admittedly, I recently wrote a blog using the “silver lining” line. Why? Because it is true!
What is tax-loss harvesting?
Tax-loss harvesting is the process of realizing losses on investments that have a market value below its adjusted cost basis (meaning it’s worth less than what you paid). When done successfully, tax-loss harvesting allows you to create a tax asset: realized losses that can be used to offset against realized gains in the current year or carried forward into future years, indefinitely. Harvested losses – done properly – can be used to lower one’s tax bill across their portfolios.
What could go wrong?
1. Is the juice worth the squeeze?
Tax-loss harvesting is not a means to an end. Higher after-tax wealth is the end goal, not simply tax-loss harvesting because the market is down. You need a process to critically analyze each tax-loss harvesting opportunity.
a. What are the trading costs associated with the potential transaction costs?
b. Do you have an equal or more compelling investment to transition to?
c. Do you know your client’s tax situation? Does their marginal tax rate even warrant loss-harvesting?
Don’t tax-loss harvest just for the sake of it. You need a process that ensures the efforts are additive to after-tax returns.
2. Don’t be washed out
Violating the wash-sale rule may cause you to lose what you thought was a harvested loss. How? The wash-sale rule is when you buy the same or “substantially identical” security within 30 days of the day of sale. Why the quote marks around “substantially identical”? The IRS is purposefully vague on how this is defined, and they are the final arbiter. When in doubt, consult a tax professional.
Note that you cannot avoid the wash-sale rule if you sell a security in a taxable account and purchase the same (or substantially identical) security in your 401k. This trade would disallow the tax asset you were looking to create.
3. Don’t get lost
Tracking error: Too often, investors are so intrigued with the idea of creating a tax asset through tax-loss harvesting, that after the tax-loss harvesting trade, the new portfolio does not represent the target portfolio. This different portfolio may lead to increased tracking error from the target portfolio. Does this new portfolio increase unintended biases or positions. Do you fully appreciate what the transaction does to the portfolio’s risk profile? Because of the wash-sale rule, you may have made certain investment compromises to achieve the recognized losses.
If harvesting losses creates a sub-optimal portfolio, is it really the correct approach? Again, don’t wander too far from the path and let the tracking error deviate too far from your target.
A related challenge is holding the proceeds in cash for 30 days to wait out the wash-sale rule instead of investing directly. Is holding cash part of the target portfolio? If markets are trending down, this may work. But making a market timing decision can be quite challenging. Don’t let holding cash be a drag.
4. You snooze, you lose
As I wrote in a prior blog, it’s only a loss if it’s realized (you actually make the trade). Many advisors look for tax-loss harvesting opportunities at year-end. That might fit one’s operational calendar, but the market moves independently. Historically*, markets have – on average higher monthly returns in November and December – the very time when many look for tax-loss harvesting opportunities. And recall what markets did during the sell-off during the onset of COVID-19 in March of 2020. Equity markets rallied so quickly, the tax-loss harvesting opportunity was gone before many had the opportunity to take advantage of the pullback. See the exhibit below.
5. Fortune favors the brave
Contrary to Matt Damon’s infamous quote in his Super Bowl crypto commercial, we believe fortune does favor the brave in terms of executing successful tax-loss harvesting trades in taxable accounts. We’ve listed several challenges around tax-loss harvesting, but it’s not a knock against the process.
When done properly with thoughtful analysis, successful tax-loss harvesting can lead to improved after-tax wealth for investors. The biggest mistake is to not take the entire process into consideration – and when beneficial – pull the trigger and execute the desired trades.
At Frontier Asset Management, we’ve been managing investors’ taxable strategies for more than 20 years. During this time, we’ve learned a lot about working on behalf of investors to actively manage portfolios seeking to maximize after-tax returns.
We have a 14-member investment team that includes nine CFA’s representing decades of combined trading experience and a time-tested process around tax-loss harvesting that takes all the previously mentioned pitfalls into consideration. Our forward-looking process uses tax-loss harvesting as an opportunity to reposition our strategies to reflect our views on the market and helps to manage to our Downside First Focus.
In May of this year within our Tax-Managed Balanced Strategy, we liquidated a position in the Vanguard Tax-Managed Balanced Fund. This remains a compelling fund for taxable accounts and includes allocations to both U.S. equities and passively managed municipal bonds in a single fund. But due to market volatility, the liquidation of this fund (and harvested loss for investors in a loss position) allowed us to deploy those proceeds into different passive municipal bond exposure and an active U.S. equity fund looking to take advantage of the recent sell off in growth names. The trade resulted in similar (but substantially different) municipal bond exposure and an active equity manager and created a tax asset for many investors.
Putting it together
Given the market volatility of late, you will undoubtedly see and hear more about tax-loss harvesting between now and year-end. Remember, this volatility has impacted both equity and fixed income investments. Consider the entire portfolio – not just equities. There are many ways to approach tax-loss harvesting incorrectly, but when done properly, it can materially improve after-tax returns for investors. And yes, it puts the silver lining, the lemonade and upside to tax-smart investing for the brave (even more nickels).
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* “Stock Market Indicators: Historical Monthly & Annual Returns”, Dr. Edward Yardeni and Joe Abbott, June 1, 2022 https://www.yardeni.com/pub/stmktreturns.pdf
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