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Fundamentals of Tax Loss Harvesting Tax loss harvesting is the intentional selling of portfolio positions at a loss for the purpose of offsetting capital gains and managing an investor's tax liability. Below we dive into everything investors need to know when it comes to tax loss harvesting. What are the potential benefits? • Helps to manage an investor's current tax liability - Tax loss harvesting can be an effective tool in managing an investor's current tax liability by offsetting the capital gains that are realized elsewhere in the investor's portfolio. • May help reduce an investor's tax liability in future years - Investors may be able lower future tax liability by "banking" losses, which entails harvesting more losses than are needed to offset a given tax year's realized gains. These "banked" losses can be used to offset capital gains that may be experienced in future years. What are the drawbacks/risks? • Introduces potential portfolio risk – By selling a portfolio position for the specific purpose of generating a loss, an investor's actual portfolio is deviating from the intended portfolio. This can introduce unintended risk, or tracking error, to the portfolio. Investors should understand this risk and take steps to mitigate it if they are selling positions simply to generate losses. • Can result in portfolio "lock" – When an investor aggressively loss harvests, it can result in a portfolio selling all positions that have losses leaving the portfolio only with positions that have unrealized gains imbedded in them. If the investor is highly tax sensitive and does not want to realize capital gains, the portfolio can essentially become "locked" because the only trading that is possible will generate capital gains the investor does not want to experience. • Reduces a portfolio's cost basis, which may result in higher taxes in the future – When investors harvests losses, they typically reinvest the proceeds generated from those losses back in the market. However, when they do that, it is typically when the market is down. Therefore, they are investing at a fairly low price. While "buying low" is beneficial from a return standpoint, from a tax standpoint it can result in an investor trading a loss today for a larger gain in the future and potentially offsetting entirely the benefit of the loss harvest. • Can result in unrealized short term gain positions after the wash sale period expires – Investors often loss harvest when the market experiences a significant downturn, which is intuitive since that is when there are likely to be significant losses available to harvest. However, the market often experiences a rapid recovery after a significant downturn. If the investor reinvests the proceeds of the loss harvesting, as is typically done, the investor may end up holding positions with significant unrealized short term capital gains once the wash sale period ends. Example of Tax Loss Harvesting Risks Let's illustrate one of these risks... Whenever a steep sell-off occurs, markets tend to bounce back pretty quickly. Here's a look back at some of these downturns over the past 15 years. 2007 2021 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2022 2020 2019 -55.25% 356 Days -12.96% 144 Days -10.10% 9 Days -19.36% 66 Days -12.82% 18 Days 10.82% 31 Days 12.38% 31 Days 25.29% 31 Days 8.21% 31 Days -33.79% 24 Days 22.24% 31 Days 8.73% 23 Days Loss Harvesting in Volatile Markets Source: Envestnet | PMC. S&P 500 Daily Returns. January 1, 2007 – March 31, 2022. 1 2 3 4 5 6 Many investors who harvested losses during these market downturns had the economic benefit of those losses reduced due to the market rebound during the 31 day wash sale period. Let's take a look at how a hypothetical $10,000 investment at the market's peak, would have fared if losses were harvested at the bottom of the market: $1,110.00 $744.48 $479.52 $131.71 $202.00 $716.32 $346.34 $1,250.23 $630.44 $474.34 $193.71 $(280.63) $(619.79) $(369.98) $(272.76) Tax Savings $(70.76) $(347.81) $(365.52) Economic Benefit Lost: 33% Tax Cost Net Benefit Tax Loss Harvesting 31 Days Later 1 2 3 4 5 6 Economic Benefit Lost: 73% Economic Benefit Lost: 135% Economic Benefit Lost: 52% Economic Benefit Lost: 50% Economic Benefit Lost: 59% Source: Envestnet | PMC. S&P 500 Daily Returns. January 1, 2007 – March 31, 2022. Here's a closer look at how this would have panned out for investors towards the end of 2018: • This hypothetical illustration shows a $10,000 investment into an S&P 500 ETF at the peak of the market in September 2018. • The position is then sold at the bottom of the market in December to maximize the tax loss of $1,936. • The remaining value is then reinvested into a replacement S&P 500 ETF. • That new position is then sold at the end of the 31 day wash sale period to reinvest back into the original ETF, but by that time the investor already has a $999 short term gain. • This short term gain reduced the benefit of the tax loss harvest by over 50%! Source: Envestnet | PMC. S&P 500 Daily Returns. September 20, 2018 – February 19, 2020. September 20, 2018 December 24, 2018 January 23, 2019 66 Days -19.36% 31 Days 12.38% of the Economic Benefit is lost due to unwinding the Tax Loss Harvesting Investment Gain/Loss Ending Value Economic Benefit Peak $10,000 ($1,936) $8,064 $716 Trough $8,064 $999 $9,063 ($370) Net $346 52% Want to better manage your clients' taxes? + - The information, analysis, and opinions expressed herein are for general information only. Nothing contained in this document is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. Investing carries certain risks and there is no assurance that investing in accordance with the portfolios mentioned will provide positive performance over any period of time. Investors could lose money if they invest in accordance with the portfolios discussed herein. Past performance is not indicative of future results. 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