Tax Loss Harvesting
Turning Portfolio Pain into Planning Alpha – Pt. 2
Tax-loss harvesting (TLH) can be a useful tool for minimizing the effects of taxes, helping your clients make the most of their financial plans and portfolios. However, a delicate balance and careful planning is required to reap the benefits of tax-loss harvesting without causing unintended consequences. There are drawbacks that should be considered before executing TLH strategies or adding TLH to an account.
Downsides and Pitfalls
The most common compliance issue with TLH is the wash sale rule. If a “substantially identical” security is repurchased within 30 days before or after the loss sale, the IRS disallows the loss. This rule includes potentially all the investors’ securities accounts, not just the account used for the loss harvesting1. A wash sale can generally be clearly applied to individual securities, however, when it comes to mutual funds and ETFs, the IRS is a bit foggier in their definition of “substantially identical.” In fact, there is no explicit mention of what this phrase means for an investment vehicle that bundles securities together to track a broader index. In this explicit case, it is up to the advisor to determine the suitability of a subsequent purchase after realizing a loss. The IRS could, in theory, push back and disallow a loss on the sale of say “SPY” and the re-purchase of “IVV” or “VOO” (all funds tracking the S&P index). Alternatively, the buyback of a large-cap ETF such as Vanguard’s “VV” may not trigger this wash sale2.
Other challenges include:
- Capital re-deployment risk: Staying in cash too long after a sale can cause missed rebounds.
- Cost basis trap: Harvesting losses now lowers the client’s basis, which potentially increases future tax if sold again without a step-up, or if sold in a higher tax bracket than the loss was initially harvested1.
Who It Helps and Who It Doesn’t
While TLH can be a powerful tool in an advisor’s arsenal, TLH strategies should be evaluated on a case-by-case basis as opposed to a one-size-fits-all recommendation1.
TLH is generally useful for:
- High-income investors with large, realized gains or recurring withdrawals
- Retirees who are near income thresholds that impact tax brackets or government benefits (e.g., IRMAA for Medicare or capital gains thresholds)
- Investors who hold volatile securities in taxable accounts
- Clients who anticipate lower marginal tax rates in the future, benefiting from tax arbitrage**
**Tax arbitrage: Tax arbitrage is the strategy of exploiting differences in tax treatments across jurisdictions, entities, or financial instruments to reduce overall tax liability or enhance after-tax return. In the context of TLH, tax arbitrage occurs when an investor uses realized losses to offset income or gains taxed at high rates today (e.g., 37% Short-Term Gains + 3.8% Net Investment Income Tax or 20% Long-Term Capital Gains + 3.8% Net Investment Income Tax) and defers realizing gains until a future year when their marginal tax rate is lower, effectively converting high-rate tax into low-rate tax.
TLH is generally less useful for:
- Low-income investors in the 0% capital gains bracket
- Investors with most of their assets in tax-deferred or Roth accounts
- Those without gains to offset
- Clients who have planned withdrawals within 12 months of utilizing TLH, as they may realize short-term gains and be taxed at higher rates
1 Michael Kitces, “What Advisors Need To Know About Tax Loss Harvesting: Scaling, Execution Challenges & Wash Sale Rules,” Kitces.com
2 Sheryl Rowling, “Wash Sale Challenge: What Is Substantially Identical?” https://www.morningstar.com/financial-advisors/wash-sale-challenge-what-is-substantially-identical
For Use with the General Public. Financial Planning and Advisory Services offered through Vicus Capital, Inc., a federally Registered Investment Advisor.
