Tax harvesting

Christine A. Pederson, CAIA, CIMA | Senior Director, Equity Manager Research

Key Points

  • Taxes can reduce investment returns
  • A tax harvesting plan can enhance after-tax returns
  • Market movements and rebalancing present opportunities to tax harvest

While we believe it is prudent to manage the administrative costs related to investments, it is also prudent to manage the cost of taxes when investing. Taxes are one of the highest costs an investor faces, even if utilizing tax-deferred accounts as at some point distributions from those can become taxable. A tax-aware investment strategy should incorporate both tax loss harvesting and a plan for recognizing capital gains.  

Impact of taxes on investment returns

Since taxes can reduce investment returns, we believe a consistently applied tax strategy can improve results. When considering a long-term investment horizon, the tax impact on wealth can be substantial. We compare the difference over 25 years between a non-qualified, fully taxable investment (blue bar) to an equivalent investment in a Roth IRA that accumulates and distributes tax-free (teal bar) as shown in the chart below.

Chart assumptions: Each account has an initial contribution of $10,000 of after-tax dollars and earns a hypothetical average annual gross return of 6% of ordinary income, which does not represent the actual return of any investment and may not be indicative of what you may experience. A 24% ordinary federal income tax is assessed each year on the earnings in the nonqualified savings account, assumed here to be interest-bearing. The Roth IRA grows tax-free but was initially funded with after-tax dollars. 
State taxes are not considered in this example, nor are federal or state alternative minimum tax. Lower tax rates on capital gains and dividends would make the investment return for the taxable investment more favorable, thereby reducing the difference between the investments shown. The tax rates and tax treatment of earnings may impact the comparative results. The tax-deferred accounts may be subject to an IRS 10% penalty, in addition to ordinary taxes, for distributions before age 59 ½ unless certain conditions are met. Losses recognized on taxable investment may provide current income tax benefits, potentially increasing the favorability of taxable accounts. Any federal and/or state tax penalties (e.g. for early withdrawals or use on nonqualified expenses for education plans) would reduce the figures for tax-deferred investments. Fees and transaction costs would reduce the figures shown.   
 

Tax harvesting to enhance after-tax investment returns

While no one expects to lose money on an investment, the reality is that if you assume risk to earn a higher return, the potential for losses exists. A long-term investment horizon can help mitigate the impact of losses. However, a loss doesn't have to be all bad news, and the tax code provides investors with ways to reduce the sting. Tax loss harvesting is one way of taking advantage of market losses by realizing losses on investments that may no longer merit inclusion in your portfolio. Three ways to make the most of market losses include offsetting anticipated capital gain distributions from mutual fund holdings, rebalancing back to your strategic allocation, and reducing a holding with a sizable capital gain.

If an investment may not recover in value due to a change in the fundamental thesis, consider selling and realizing those losses. Selling while those stocks are pressured may offer a more significant benefit than waiting to year-end as the market may have recovered with fewer losses available later. To avoid the wash sale rule, another non-identical investment can be purchased, or the proceeds can be kept in cash for the period which is 30 days before and after the date of the sale, without reinvesting in the security. If your capital gains are substantial, you may want to consider employing a detailed tax-loss harvesting strategy with your advisor and tax preparer.

Based on current tax treatment, capital losses can offset capital gains by first netting long-term (more than one year) gains/losses and by netting short-term (one year or less) gains/losses. The results from each calculation are then netted, leaving a net capital gain or loss. You may use net capital losses in any tax year to reduce up to $3,000 of other income, and any excess is carried forward to use in future tax years.

An example of tax harvesting potential benefits

Assume we have a strategic allocation in a non-qualified account that is split between a growth and value stock where the growth stock returned 30%, while the value stock declined by 15%.

Let’s look at the potential impact different tax strategies could have on wealth: 100% gain and netting gains/losses for both long-term capital gains and for short-term capital gains. In each example, the ending wealth is $107,500 less taxes.

 

 

Let’s look at the potential impact different tax strategies could have on wealth: 100% gain and netting gains/losses for both long-term capital gains and for short-term capital gains. In each example, the ending wealth is $107,500 less taxes. 

Long-term capital gains: stock held for more than 12 months

Short-term capital gains: stock held for less than 12 months

 

The amounts presented in the tables above do not account for transaction costs that would reduce net amounts. *The Long-term capital gains are taxed in 2021 at 15% for Single Filers with taxable income of $40,400-$445,850 and for Married filers of $80,800-$501,600. For Single or Married Joint filers with modified adjusted gross income above $200,000 or $250,000, respectively, an additional 3.8% net investment income tax. **Short-term capital gains are taxed at ordinary income rates. In 2021, the 24% tax rate applies to Single filers with taxable income of $86,375-$164,925 and for Married, joint, filers taxable income of $172,750-$329,850.
Source: Ameriprise Financial Services, LLC.

The analysis shows that the higher the tax rate, the more critical tax-aware investing becomes, and that ending wealth can be enhanced through tax loss harvesting. While not always possible, tax-aware investing should be a priority to receive more favorable tax treatment and enhance returns over time.

Resetting the cost basis

A tax strategy recently gaining traction is to sell an investment with a large embedded long-term capital gain and repurchase the same investment, to reset the cost basis. The recent interest is being driven by platform statements made by the Biden administration. They have stated a desire to raise the long-term capital gain rate (today 23.8% maximum) to ordinary income tax rates (top current marginal rate is 37%) for certain very high-income taxpayers. 

The strategy's goal is to avoid possible higher capital gains rates in the future by paying them today.  However, to qualify for the favorable capital gains tax treatment, the investment needs to be at economic risk, meaning you can't sell and immediately repurchase. The question is, how long does an investor need to be out of that investment. The IRS has not defined the required time (unlike wash sale rules), so we recommend consulting a tax professional for guidance.

What you earn matters, but more important is what you keep. A well-crafted tax strategy could reduce the cost of tax drag.

Other considerations

Trading costs can offset some of the tax benefits and are important to consider. Also keep wash sale rules in mind. They can disallow a loss if you purchase identical or substantially identical securities within the wash sale window, defined as 30 days before or after the sale at a loss.

Suppose you made multiple purchases of the same security on different dates. You can work with your advisor to identify an exact lot of shares to sell to take advantage of the sale's tax implications. This is called tax lot identification. You must identify the tax lot you wish to sell at the time of sale.        

Additionally, it’s critical to remember that tax law changes and each investor’s circumstance is unique. It is important to consult with a tax professional before putting tax strategies in place.

In conclusion

Taxes are an unavoidable cost of investing, but a consistently executed tax management strategy can improve after-tax returns. Tax harvesting has historically been underutilized, but the evidence supports the value of such an approach. 

Please consult with your income tax advisor for advice customized to your specific situation.

Our advisors partner with your tax professional to help determine the best approach to tax strategies.

Or, request an appointment online to speak with an advisor.

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