May 2022
Tax-loss harvesting is an investing technique where loss positions in a portfolio are deliberately sold to generate capital losses.
Capital losses have three useful benefits for investors if properly "harvested":
Reduce capital gains taxes in the current year
Capital losses can offset your capital gains to reduce your current year tax bill
Reduce ordinary income taxes in the current year
If your capital losses exceed capital gains for a year, you can reduce your ordinary income by up to $3,000 per year
Reduce capital gain and ordinary income taxes in future years
If your capital losses exceed capital gains for a year beyond $3,000, you may be able to carry the loss forward to future years to offset future ordinary income and capital gains
If investment losses are life’s lemons, then tax-loss harvesting is what you can use to make lemonade. When stock markets are on the decline, lemons are raining from the sky and there are easy opportunities for tax-loss harvesting. However, when stock markets are on the rise, the sun is shining and many investment managers don’t collect any lemons to tax-loss harvest. This is a missed opportunity; tax-loss harvesting experts can usually make lemonade in even the brightest of markets.
Below is illustration of tax-loss harvesting comparing two investors: one investor that simply uses ETFs to invest in a popular market index and another investor that uses advanced tax-loss harvesting tools to hold the same index.
Tax-loss harvesting illustration
Consider the popular S&P 500 stock index. The S&P 500 has performed quite well considering the past 10 years through 2021. The only calendar year with negative total returns during that decade was 2018, so you could be forgiven for thinking most of those years did not have significant tax-loss harvesting opportunities. Let’s explore how investors could have faired for tax-loss harvesting in 2021, which had a strong 27% price return for the S&P 500.
ETF Investor
If you simply invested in an S&P 500 ETF at the beginning of the year, all of your shares would have the same gain embedded in each share (approximately a 27% gain for each share). This would provide no tax loss harvesting opportunities at the end of the year because there would be no losses to harvest.
However, many ETF investors may be exposed to different sectors of the S&P 500 through sector specific ETFs (e.g., Industrials ETF, Real Estate ETF, Information Technology ETF, etc.). If you invested in each of the sectors of the S&P 500 with sector ETFs, would any of those sectors have provided tax loss harvesting opportunities at year-end?
No - as illustrated in the graph below, each of the sectors of the S&P 500 had positive price returns ranging from 14% to 48% for 2021.
Direct Indexing Investor
Direct indexing is an investing technique where investors hold the underlying stocks of an index directly. Advanced portfolio construction techniques can even replicate the returns of an index without holding all of the underlying stocks of an index. An investment manager can calibrate a direct indexed portfolio to carefully manage a client's after-tax performance while simultaneously minimizing any tracking differences between the portfolio and the index.
How would an investor in the S&P 500 have faired from a tax-loss harvesting perspective if they used direct-indexing in 2021? Take a look at the graph below to find out. It charts the annual price returns of each of the stocks in the S&P 500 for 2021 with a thin bar for each stock. The stocks are sorted from the worst performers on the left-side (i.e., the red bars) up through the highest performers on the right-side (i.e., the green bars). For reference, a grey line runs across the graph to illustrate the 27% return of the entire index and how the performance of the individual stocks are widely disbursed above and below that line.
From reviewing the graph, you can see that even with a S&P 500 price return of 27% in 2021, the index still had more than 70 individual loss positions. Losing positions averaged over 10% in losses for the year and several exceeded 30% in losses. Through direct-indexing, an investor could have achieved a price return of 27% on the portfolio for 2021 while still harvesting many individual loss positions. This technique can enhance an investor’s after-tax returns by building up capital losses to reduce taxes on ordinary income and capital gains in current and future years.
This is only an illustration and the numbers will of course change based on how returns and tax rates differ from investor to investor over time. The core lesson is that investors with more assets and higher taxes stand to benefit more from this strategy as their savings and income grow.
Conclusion
Most investors accept the reality of volatile markets, but few have built portfolios that are designed to profit from that volatility. Direct-indexing profits from volatility by allowing investors to improve after-tax returns through diversifying their tax positions across both the winners and the losers of the market while still achieving the same aggregate returns of the wider market.
At Andante Financial, our mission is to elevate the standard of investment management. To learn more about how we use this and many other strategies to enhance our clients' financial wealth, click the link below.
コメント