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Return to My Accounts
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 many of those accounts 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 may improve results. When considering a longterm 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.
nonqualified savings account, assumed here to be interestbearing. The Roth IRA grows tax-free but was initially funded with after-tax dollars, as well.
Tax harvesting to enhance after-tax investment returns
While no one expects to lose money on an investment, the reality is that you necessarily assume risk to earn a higher return, and 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 is not expected to 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 yearend as the market may have recovered with fewer losses available later. If you wanted to take the loss but still believe the security is an attractive long-term investment, you need to be aware of the wash sale rule1. To avoid the wash sale rule, another security can be purchased, provided that it is not substantially identical to the security sold (including options contracts), 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 net capital gains or losses. You may use net capital losses in any tax year to reduce up to $3,000 of other income, leaving any excess net capital losses to be 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.
Long-term capital gains: stock held for more than 12 months
Short-term capital gains: stock held for less than 12 months
*The Long-term capital gains are taxed in 2022 at 15% for Single Filers with taxable income of $41,675-$459,750 and for Married Joint filers of $83,350-$517,200. 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 applies.
**Short-term capital gains are taxed at ordinary income rates. In 2022, the 24% tax rate applies to Single filers with taxable income of $89,075-$170,050 and for Married Joint filers taxable income of $178,150-$340,100.
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 in response to potentially higher capital gains tax rates in the future is to sell an investment with a large embedded long-term capital gain and repurchase the same investment, to reset the cost basis. The interest is being driven by recent attempts from the Biden Administration to include higher capital gains rates within certain legislative bills. To date, those efforts have failed to garner sufficient support from Congress but remain on the table as a desired outcome by the Administration. You may also want to take gains if you have sustained significant losses or if you expect your future income to move you into a higher capital gains rate.
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. The IRS can disallow a loss if you purchase identical or substantially identical securities (including options contracts) within the wash sale window, defined as 30 days before or after the sale at a loss. The interpretation of what constitutes substantially identical securities has nuances and is best addressed by a tax professional. Also, note that activity undertaken in another ownership type, such as an IRA or trust over which the taxpayer has complete control, may impact the ability to claim the 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 help improve aftertax 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.
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