Tax-loss harvesting: More than just deferral, Part I

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Tax-loss harvesting strategies are often thought of as a deferral strategy with investors utilizing tax benefits in the short-term only to have a tax bill remain due at a later date when the strategy is sold. Although we would agree that deferral is an important benefit to any tax-loss harvesting strategy, there are a few additional benefits that we’d like to touch on. In this piece, we present three different tax benefits: pre-tax compounding, deferral, and differential.  

Institutions managing tax-deferred portfolios typically have a major advantage over taxable investors in that they can fully compound investment returns without regard to any tax considerations. Taxable investors typically pay tax on any gains distributed during the year, which results in a two-steps-forward, one-step-back outcome that may provide a drag on portfolio growth over time. As tax-loss harvesting strategies generally do not realize net taxable gains, they may enjoy the same benefits as institutions by compounding investment returns on a pre-tax basis. Additionally, the tax benefits generated by a tax-loss harvesting strategy may also help other higher-return, tax-inefficient investments in a portfolio compound faster, potentially improving the investor’s entire tax profile in a holistic manner.

Perhaps the best-known benefit of tax-loss harvesting is the deferral benefit. An investor can utilize the benefit of any tax losses generated in the current year, helping to offset any tax liabilities. The tax savings can be reinvested in the current portfolio, potentially compounding at the total portfolio’s expected return for enhanced after-tax wealth. Investors would likely have to pay long-term capital gains on the amount that the tax basis of the portfolio has been depleted when the portfolio is sold, but the time value of money works to the investor’s advantage through enhanced compounding along the way. Ultimately, if the portfolio is used as a charitable donation or steps up in basis, any tax benefits earned may become permanent.

Tax-loss harvesting strategies typically seek to generate a large amount of short-term capital losses and a small amount of long-term gains consistently from year to year. Investors can use the benefit of the short-term capital losses to offset any short-term capital gains, which tend to be taxed at higher rates. In turn, the strategy may also generate a relatively small amount of long-term capital gains, which tend to be taxed at relatively lower rates. Investors may use the tax benefits to offset liabilities taxed at high rates, while paying long-term gains at lower rates. This differential between short-term and long-term rates at the highest rate is currently 17% (40.8% - 23.8%), a permanent benefit that investors may be able to enjoy from year to year

In part II to follow, we’ll illustrate these three benefits using a simple framework. In part III, we’ll also present each benefit in the scenario that long-term capital gains rates are normalized to the level of short-term gains as recently proposed by the Biden administration. There is no question that tax policy could have an impact to these benefits going forward, but we believe that the combination of the three discussed can add value to investors both at current rates and in any number of potential scenarios ahead.

Categories Tax

This post is not intended or presented as investment advice, and any discussion of a particular investment should not be construed as a recommendation of such investment. Readers should consult their own tax, legal, accounting or financial advisors before engaging in any investment transaction.

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