Tax-Loss Harvesting: A Potentially Impactful Year-End Strategy

As we approach year-end 2020, we look back on a year in the capital markets that has been both volatile and, ultimately, positive for investment returns. While we are all looking forward to 2021 and closing the book on 2020, the pressure created in various sectors of this year's market still may have a gift to give.

For high net worth families with taxable investment accounts, year-end planning should include strategies around tax considerations. Specifically, tax-loss harvesting is an important tool that should be considered every year to mitigate a family's tax bill due next April.

In prior communications throughout the summer and fall, our team has focused upon the November presidential election and the potential tax implications of a Biden or Trump administration over the next four years. These considerations around future income tax, estate tax and capital gains tax are clearly important—though as we write this today in late 2020, there still exist several unknowns with respect to the tax code over the next four years.

What we can focus on this year, which will provide concrete and near-term tax benefits to our taxable clients, is tax-loss harvesting.

In a Nutshell

For investors, the end of the year gives the advantage of looking back over the current year and considering the opportunities for tax harvesting. It may sound counterintuitive to realize losses proactively in an investment portfolio. Why go through the trouble? Isn't it typically best to buy and hold investments for the long-term? The simple answer is that the tax benefits of harvesting portfolio losses can be very valuable.

Because the past decade of returns in the global stock market have been robust, most clients have embedded gains in their portfolio. For example, many investors have reaped the rewards of over a decade worth of substantial gains in technology and other growth-oriented stocks. If a family has had to raise cash for income in their portfolio or simply rebalance their existing holdings to better reflect their asset allocation, they have likely incurred some realized capital gains.

The realized gains that many clients have experienced this year can be taxed at either a short-term or long-term capital gains rate, depending on how long they have held the security. For families in the highest income tax bracket, the Federal long-term capital gains rate is 20%.

Let's consider a high net worth family that has realized $100,000 of long-term capital gains from rebalancing and trading so far this year. As it stands today, the family would have a tax liability of around $20,000 due next April, just from the sales of these holdings. Within this family's investment portfolio, most of their investments have appreciated this year.

Consider, however, that there may be a few funds and individual securities in this family's portfolio that have a net loss. When combined, let's say the family has $50,000 of losses. If these losses were to be harvested this year, they would be netted out against the existing $100,000 of realized gains. The result would be a reduction of the family's realized gains to $50,000—resulting in a substantially lower tax bill of about $10,000 due next April.

Do's and Don'ts

It's important to implement a tax-loss harvesting strategy with a number of best practices. Staying invested and avoiding the "wash sale" tax rule are the two most important considerations.

As part of the tax code, investors have to be aware of the wash sale rule for harvesting losses. What this means is that if an investor sells a security today and realizes a loss, they cannot buy back into same exact security, or something substantially similar, for the next 30 days. If they do so, the harvested loss would be disallowed.

We want our clients to maintain their investment objectives, which means that over time, they stay invested, even while honoring the wash sale tax rule. The solution is to buy securities that are very similar to what has been sold but not identical. or example, if a client sells a large-cap U.S. mutual fund for a loss, they could re-invest the proceeds in a similar, but not identical, large-cap U.S. mutual fund or ETF. We want the investor to receive the same type of investment exposure during the 30-day period when they cannot purchase the original security. On day 31 or later, the investor can then buy back the original security that they sold.

Keeping transaction costs low is another best practice for ensuring that tax-loss harvesting is ultimately successful. Fortunately, stock, ETF and mutual fund trading costs have continued to decrease over time. The trading costs involved with exercising a tax-loss harvesting strategy depend on the custodian, though the transaction costs today in our industry are typically extremely low.

Final Considerations

It is almost always the right decision to harvest investment losses in a year when a family's taxable portfolio has experienced realized gains.

What if there have been little to no realized gains or distributions in a given tax year?

There are still two important tax considerations in a year of minimal realized gains. First, a high net worth family whose capital losses outweigh their capital gains may deduct the difference, up to $3,000 (married filing jointly) in losses on their tax return. Second, due to positive market returns over the past several years, it is likely that investor portfolios have seen appreciation in their stock holdings. Rebalancing is an important exercise for portfolios, which will inevitably result in some degree of realized gains. A proactive investor can rebalance this year and realize some gains in their portfolio, knowing that they have several positions that can be harvested for a loss that will offset the realized gains. These strategies may help an investor get back to balance within their portfolio, by also taking some gains off the table and minimizing the resulting tax burden.

Each family's investment portfolio, and realized gains and losses, are very custom to their situation. The benefits of harvesting losses within a taxable investment account are very attractive and should be an important discussion item with your advisor as we approach year-end 2020.

While we await more clarity on future tax law and potential changes, tax-loss harvesting in December 2020 is a proactive and valuable strategy for taking effective action now. We encourage our clients to consider tax-loss harvesting with their wealth advisor and in coordination with their tax professional.