Do tax-loss harvesting strategies boost after-tax returns?
Many hypothetical, backtested performance claims imply that they do — and by a lot. But advisers should think twice before using these claims to set client expectations. The value added by such strategies depends on future market environments and an investor’s circumstances.
In “Tax Management, Loss Harvesting, and HIFO Accounting,” Andrew L. Berkin and Jia Ye highlight how market environments, portfolio cash flows, and tax rates influence the effectiveness of tax-loss harvesting strategies. They conclude that markets with higher stock-specific risks and lower average returns offer the most fertile ground for such strategies. They also show that a steady stream of contributions reinvigorates a portfolio and helps maintain the benefits of tax-loss harvesting over time. On the flip side, large withdrawals are counterproductive to such strategies, while the advantages tend to be related to an investor’s tax rate on a roughly linear basis.
These findings suggest that tax-loss harvesting’s potential benefits depend on an investor’s financial situation and must be weighed against the risks.
Harvesting a loss might generate tax savings today, but it reduces the cost basis of the investment and could raise future tax liability. If the investor’s tax rate increases in the future, the tax deferral benefit of the harvested loss could diminish. Conversely, if the tax rate decreases, the deferral benefit could be amplified.
Many pro tax-loss harvesting studies assume the investor’s tax rate remains stable over time. This is often unrealistic. Rates can change drastically based on shifts in policy or life events. Current federal income tax rates in the United States are scheduled to sunset after 2025, which may mean higher marginal tax rates. Jason Zweig demonstrates how harvesting losses can backfire if tax rates go up in the future. The Trump administration is said to be considering a capital gains tax cut. Christine Benz argues that investors temporarily in lower tax brackets might want to harvest gains, not losses.
The trading required to implement these strategies also creates risks. By helping an investor realize the economic benefit of a loss without materially changing the risk/return characteristics of their portfolio, tax-loss harvesting can be at odds with tax law. According to the IRS’s wash sale rule, if an investor buys the same security — or any security — that is “substantially identical” within 30 days before or after selling at a loss, the loss is disallowed. Advisers attempt to circumvent the wash sale rule by “tax swapping,” or selling securities at a loss and using the proceeds to purchase similar but not “substantially identical” securities.
Tax swapping is not perfect: It exposes investors to the risk that the new security underperforms the one that was sold at a loss, which could negate the expected economic benefit of the trade.
A Warning on Hypotheticals
Many advertisements for tax-loss harvesting strategies contain hypothetical backtests that are loaded with very specific assumptions. Theses backtests cherry-pick scenarios: The investor may be heavily weighted in volatile assets, in the highest tax brackets, make consistent portfolio contributions, have few liquidity needs, or be subject to a large bear market at the beginning of the measurement period. Such circumstances are not applicable in many cases and may produce results that set investor expectations too high.
Results from backtests might also lead an investor to underestimate the risks. For example, timing when to sell investments at a loss and immediately identifying securities that will match their performance in the future is much easier to do with perfect hindsight.
There is nothing inherently wrong with illustrations containing backtested performance data. If they meet certain standards, they can help investors understand how a recommended strategy might perform under certain conditions. But advisers should always consider the number of disclosures required — and the audience’s sophistication. Advertisements that tout the backtested performance of tax-loss harvesting strategies are often very complex and require heaps of fine print. Most retail investors are not savvy enough to sort through all the “what ifs.”
Tax-efficient portfolio management cannot take place in a vacuum. It requires customization and regular communication as well as input from an investor’s tax adviser. Investors who are in high tax brackets, can use long-term losses to offset short-term capital gains and ordinary income, or can defer capital gains indefinitely might make good candidates for tax-loss harvesting. But those in lower tax brackets with shorter time horizons may have less to gain. Of course, even these scenarios represent generalizations and should be considered with other factors and risks.
It’s impossible to say for certain that tax-loss harvesting will significantly boost after-tax returns without knowing very specific details about the investor’s financial situation. Such strategies were never meant to be bottled up and sold to the masses as turn-key trading schemes. Advisers and investors should be wary of promotions that claim a tax-loss harvesting strategy will enhance a portfolio’s after-tax returns by some specific amount.
What’s your take on tax-loss harvesting strategies and how they are being sold to retail investors? Tell us in the comments below.
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer
Image credit: © Getty Images/z_wei
David L. Allison, CFA, CIPM, is vice president and founding partner at Allison Investment Management, LLC. He has formal training in investment analysis, portfolio management, and investment performance measuring techniques. He has extensive experience managing investment portfolios for high net-worth investors. Allison is an active member of CFA Institute and the CFA Society of South Carolina, where he is a former president and currently serves on the board of directors. He holds a degree in finance from the University of North Carolina at Wilmington. Advisory services offered through Allison Investment Management, LLC. Securities offered through Triad Advisors, LLC. Member FINRA & SIPC. Allison Investment Management, LLC is a Registered Investment Advisor and is not affiliated with Triad Advisors, LLC.