Tax-loss harvesting can help investors reduce their tax bills significantly by selling investments that have declined in value and replacing them with highly correlated assets that will preserve your portfolio’s risk and return profile.
However, it’s essential to weigh the value of this strategy against trading costs and other considerations before implementing it.
Diversification
Diversification is essential to any investment portfolio, as it helps reduce volatility and boost long-term returns. When combined with proactive tax management strategies, diversification can become an effective means for clients to meet their goals while keeping investments aligned with their objectives.
Imagine that your tech stock holdings have surged, leaving you overexposed to this sector compared to your other holdings. To rebalance, imagine selling off these tech stocks, realizing a large capital gain, and investing it all in industrial stocks – an action which may alter dramatically your return and lead to deviations from your desired allocation plan.
Tax loss harvesting, used alongside an effective asset allocation approach and tax-conscious investment selection, can help your portfolio align with your goals while simultaneously lowering taxes. Direct indexing strategies provide even more opportunities for tax loss harvesting as losses may be realized at individual security level rather than through ETF or mutual fund vehicles.
Taxes
Harvesting losses can provide tax savings that can be reinvested to both reduce taxes over time, as well as increase after-tax returns. Investors should however be mindful of any restrictions or rules from the IRS regarding this strategy.
Investors should understand how their cost basis of investments is calculated as this can have an impactful effect on tax-loss harvesting benefits. Cost basis is generally defined as the price paid plus brokerage costs or commissions and could even change depending on holding investments with different per-share average prices or using actual cost accounting (using multiple lots purchased over time) (known as holding multiple lots with different average prices or actual cost accounting).
Taxable accounts impose short and long-term capital gains taxes at your individual federal income tax rate, while realized losses can offset capital gains up to an amount equal to $3,000 of ordinary income, helping lower year-end taxes. Tax-loss harvesting strategies may be particularly advantageous for investors on the verge of moving up into a higher tax bracket or holding significant assets in flowthrough entities like private equity funds; however, such strategies are generally inappropriate for tax-exempt investors and those holding solely taxable retirement account investments.
Rebalancing
Rebalancing is an effective strategy to restore a portfolio to its target asset allocation. Rebalancing involves selling underperforming assets to make room for those that outshone expectations; this practice is known as tactically reallocating portfolio weights.
Rebalanced investment portfolios would have taken full advantage of 2008 market volatility by allocating more funds to equity and less to debt – then again in 2009 when equity returns surged by 76% while bond returns declined by 12%.
Rebalancing can also be performed tax efficiently by redirecting proceeds from selling over-weighted assets to underweighted asset classes, starting with international stocks and emerging markets which typically fall in underweighted categories. Redeploying proceeds allows your portfolio to reach its target asset allocation more easily with fewer transactions, thus lowering overall transaction costs. Rebalancing can be performed across all investment accounts including retirement (401(k)s/IRAs) as well as standard investments.
Automated Trading
Automating your selling and repurchasing of low-performing assets to lower taxes and potentially boost after-tax returns may help ease your tax burden and potentially enhance after-tax returns, but beware that automated programs cannot make as informed decisions on when and which assets to sell as you can do yourself. They may also introduce tracking error into your account or increase transaction fees, potentially negating any tax-loss harvesting benefits.
Investors in higher tax brackets may see particular gains from this strategy, which aims to offset capital gains and ordinary income with losses to reduce taxable capital gains and ordinary income tax obligations. Furthermore, harvested losses may provide added advantages over longer investment horizons.
Schwab Intelligent Portfolios that use loss harvesting feature automatically sell underperforming exchange-traded funds (ETFs) and then repurchase them at either their original price or lower in order to maintain your targeted asset allocation. When the market fell sharply during 2022 bear market, clients using loss harvesting saw an upsurge in ETF sales/replacements so as to capture losses while benefit from subsequent market rebound.
