Market declines like the one we are currently experiencing present great opportunities to take advantage of cheaper asset prices. Almost everyone with a taxable account should be harvesting tax losses during times like these.
What is the difference between tax-loss harvesting and market timing?
Harvesting losses is most appropriate and beneficial when it generates tax savings without disrupting or abandoning the primary investment strategy. We intentionally “lock in” losses for accounting purposes, but we don’t want to “lock out” any future appreciation. We harvest losses only when we can immediately reinvest in a suitable (but not identical) replacement that preserves our overall strategy. It would be counterproductive to sell equites at a loss only to buy bonds that have rallied.
Tax-loss harvesting might not be necessary or beneficial if a client already has very large carryover losses from prior years (the 2008 financial crisis produced a lot of big capital losses for many real estate investors and developers). Huge tax losses are helpful if they can be used to offset future income, or if they can offset gains in concentrated positions, thereby helping to diversify the portfolio.
Parsec’s three-step process to tax-loss harvesting:
- Intentionally harvest losses: For all of our clients with taxable accounts, we capture losses at every opportunity while taking into account trading charges, where applicable. We wouldn’t place a trade to generate a small loss (<$1,000) if transaction charges to sell then buy a similar security/fund would be prohibitive. But if we can generate meaningful losses, we tend to take advantage of those opportunities when we get them. We feel the benefit of the tax loss is worth the trading charges/added portfolio activity.
- Quickly redeploy the transaction proceeds: Sometimes it makes sense to place a loss-harvesting trade and leave the proceeds in cash for 31 days, then repurchase the same security. We may do this for clients who have cash needs at the end of the year with the intention of placing rebalancing trades in January when there is no more need for liquidity. When liquidity is not an issue, however, we prefer to keep the funds fully invested in another high-quality name. We may later choose to reverse the trade, once the wash sale period has expired, or we may leave the trade in place if we think it is appropriate and suits the clients’ needs.
- Decide whether to harvest offsetting gains now or to “hold” losses until future years when gains are expected to be larger or more frequent.
Who should NOT be tax-loss harvesting?
In terms of who should avoid tax-loss harvesting, I think most individual investors need to be careful that they don’t violate the wash sale rules. According to IRS publication 550, “a wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale, you buy substantially identical stock or securities,” either in the same account or in another household account, including IRAs and Roth IRAs. Stocks of different companies in the same industry are not considered “substantially identical,” nor are ETFs that track the same sector but are managed by different companies (like a Vanguard Emerging Markets ETF vs. an iShares Emerging Markets ETF). We have a process where we have already identified similar suitable replacements for situations just like this so that we can act quickly.
Older clients who may be close to getting a step-up in cost basis as a result of their death may not benefit as much from the added activity or complexity. Also, anyone who does his or her own taxes should be a bit hesitant since tax-loss harvesting creates some additional burdens in tax reporting.
How do I know if I should do tax-loss harvesting?
Capturing tax losses is one of the benefits of working with a wealth manager who is a competent, experienced fiduciary. It is part of our job to monitor your accounts and advise you to take advantages of situations like this when need-be.
Michael Baughman, CFP®
Senior Financial Advisor