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Could This Be A Good Time To Tax Loss Harvest?
In a typical year, we would move to tax loss harvest in November or December. However, this year has been anything but ordinary. After all, asset classes have all experienced sizeable drawdowns year-to-date. As the chart below shows, the S&P 500 was down nearly 20% through June, and the NASDAQ was down 27%.
Source: Twitter @skybluecircle
As a result, many investors wonder whether this type of performance across asset classes means they should harvest losses earlier than usual this year. It may be prudent to do so, especially if investors can find alternative tickers to swap into and keep similar exposure to securities without triggering wash sales or nullifying the tax loss harvest transactions as per the IRS.
Doing so earlier this year offers the benefit of realizing losses that can offset potential gains should we get a rally between now and year-end.
Specific entry points could yield different tax implications, often referred to as sequence of return risk. Further, sequence of return issues can, in fact, manifest on an intra-year basis. As the table below shows, this sequence of return risk is very real.
As a reminder, tax loss harvesting is a practice of realizing a loss to offset a gain or income, thereby reducing the current year’s tax obligation.
A capital gain or loss is the difference between the cost basis and the sale price. Usually, the cost basis is what you paid for the investment. Any gain or loss is not realized until the asset is sold. There are two types of gains and losses: short-term and long-term. Short-term capital gains and losses are those realized from the sale of an asset held for one year or less. Long-term capital gains and losses are realized from the sale of an asset held longer than one year. Short-term capital gains are taxed at marginal tax rates on ordinary income. The top marginal federal tax rate on ordinary income for 2022 is 37%, just like it has been for the last several years.
Long-term capital gains tax rates, on the other hand, are 0%, 15% or 20%, depending on your taxable income and filing status. Regardless of tax bracket, tax rates for long-term gains are generally much lower than those for short-term capital gains.
As a part of prudent investment planning, tax loss harvesting can effectively reduce the tax drag on a portfolio’s performance and provide a way to improve after-tax returns. However, to accomplish this, the strategy must be implemented correctly.
Source: Charles Schwab
For example, let’s assume that Mike has a $1,000,000 portfolio in a taxable account. By the end of 2022, Mike has recognized $100,000 worth of long-term capital gains. Without further transactions, Mike has a capital gains tax liability of $15,000, assuming his long-term capital gains tax rate is 15%. The good news for Mike is that tax loss harvesting can reduce this liability. Mike might sell some stocks and bonds that experienced $50,000 in losses. If he sells those securities, the net gain can be reduced from $100,000 to $50,000. In this scenario, harvesting tax losses would save Mike $7,500 in taxes.
According to the tax code, short- and long-term losses must be used first to offset gains of the same type. But if losses of one kind exceed gains of the same type, then excess losses can be used to offset the other type. Therefore, the most effective tax loss harvesting strategy is to apply long-term capital losses to short-term capital gains. In the previous example, if Mike’s $100,000 gains are short-term and taxed at 37%, harvesting the same $50,000 in losses would save $18,500 of the current year’s tax liability.
As you can see from this example, a tax loss harvesting strategy needs to be carefully implemented. When selecting securities that have lost value for sale, investors need to be mindful not to deviate from their target asset allocation and diversification strategy. Most investors may repurchase the same investment to maintain the proper asset mix. However, they must be careful of wash sale rules, which prohibit repurchasing a “substantially identical” security within 30 days of the selling date. At Avidian Wealth Solutions, we select secondary securities that can be purchased when primary securities are sold to harvest losses in our investment models so that we avoid triggering wash sales, thus preserving the benefits of the tax loss harvesting. Additionally, this year, we will be looking to harvest losses a bit earlier than usual.
It is important to note that the tax savings from tax loss harvesting in a given tax year can overstate the actual gains. Selling an investment at a loss and using the proceeds to purchase the same or similar security effectively resets the cost basis at a lower value and increases the embedded tax liability. If the security is repurchased and sold in the future, investors need to pay the taxes saved today through tax loss harvesting. Put another way, the economic value of tax loss harvesting is largely a tax deferral rather than an elimination of tax liability. And despite a significant drawdown in equities and fixed income securities this year, after a multi-year bull market, many investors are still holding onto gains which makes the postponed tax payment valuable in many ways.
First, the time value of money tells us that one dollar today is worth more than one dollar tomorrow. For example, if a $10,000 tax payment can be postponed for five years, an investor can simply set $9,000 on the side, invest in a 5-year risk-free treasury bond that returns 2% per year, and receive $10,000 in five years. So, he effectively pays $9,000 rather than a $10,000 tax in current dollars.
Second, the tax payment is a real cash outflow from an investment portfolio. By realizing a loss, an investor can save taxes in the current year, which increases the amount of capital available for investment. To some extent, this is analogous to a dividend reinvestment plan (DRIP). In a DRIP, the investor does not take quarterly dividend distributions as cash; instead, dividends are directly reinvested in the underlying stock. The power of dividend reinvestment manifests when compounded over long time horizons. Similarly, the longer an investor can defer the realization of capital gains and the higher the tax rate on capital gains, the more the investor will benefit from tax loss harvesting.
Third, financial assets like stocks and bonds can receive a step-up when an asset is passed on to a beneficiary upon inheritance. The step-up in basis readjusts the value of an appreciated asset for tax purposes, potentially eliminating the embedded capital gain liability.
Fourth, donating highly appreciated securities can be tax-efficient to support a philanthropic purpose. A donor not only can deduct the total fair market value of appreciated long-term assets held for more than a year but they avoid paying capital gains taxes on those securities.
Lastly, if capital losses exceed capital gains in a given year, an investor can use up to $3,000 of losses yearly to offset ordinary income in future years.
To sum up, tax loss harvesting is an active investment management strategy that potentially improves after-tax returns by deferring capital gains taxes into the future and increasing after-tax capital for investment today. Fundamentally, it reflects the most fundamental principle of finance – the time value of money. That is, when you save tax money today (loss harvesting) and pay it later, you maximize the net utility of each investable dollar in your portfolio, and in this year’s market, it makes sense to consider this strategy earlier than usual before markets resume their next bull run.
Avidian Wealth Solutions is a registered investment adviser. The information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
Avidian Wealth Solutions may discuss and display, charts, graphs, and formulas that are not intended to be used by themselves to determine which securities to buy or sell, or when to buy or sell them. Such charts and graphs offer limited information and should not be used on their own to make investment decisions.