MARKET VOLATILITY: AN OPPORTUNITY FOR TAX-LOSS HARVESTING
March 15, 2022
Periods of market volatility occur intermittently, and they are unwelcomed by most investors. Rather than confront such volatility with resignation, investors can benefit from portfolio management strategies that aim to increase their cashflow through tax-optimization programs. For example, The Mather Group, LLC (TMG) uses tax-loss harvesting (TLH), an approach intended to achieve capital gains tax deferral when individual securities or markets may have suddenly declined in value.
What is TLH? It is the potential sale of an individual equity or bond, a mutual fund, or an exchange-traded fund whose price has fallen somewhat below its purchase price. Funds generated by such a sale are then quickly reinvested into a very similar security to maintain the portfolio’s overall asset allocation mix and its risk level.
The resultant capital loss can then be used to offset capital gains realized from another asset sale, whether it is an individual equity or bond, a mutual fund, an exchange-traded fund, or even real estate. If no realized capital gains exist, then $3,000 of the loss can be used to reduce other forms of ordinary income, such as salary or interest income. Any remaining capital loss can be carried over to future years to offset other capital gains.
Let’s examine a hypothetical illustration of such a strategy, as shown in the graphic below.1 Assume two investors each invest $30,000 in a security at the beginning of the year. Their individual tax rates are the same: 20% for long-term capital gains and 30% for short-term capital gains or ordinary income. By the end of the year, their investments have each fallen by 10%, or a loss of $3,000.
The first investor does nothing further, while the second investor sells her investment for $27,000, realizing the $3,000 loss. She uses this $3,000 loss to offset her ordinary income for the year, saving $900 in income tax when calculated at 30%. She then reinvests the $27,000 resulting from this sale, plus the $900 from her tax savings, placing a total of $27,900 back into the market.
Assume that no further purchases or sales are made, but both investors decide to sell their securities when they have doubled in value. In the case of the first investor, the value has reached $54,000, achieving a $24,000 long-term capital gain. At a 20% tax rate, the after-tax results will be $49,200, for a 64% total return.
The second investor’s security has increased in value to $55,800, achieving a $27,900 long-term capital gain. At a 20% tax rate, her after-tax results will be $50,200, for an 80% total return. She will also have realized an additional $1,020 of cashflow in this TLH example. Despite the initial security loss, TLH worked to her benefit.
Switching from the hypothetical to the empirical, let’s review how TMG is implementing TLH for its clients. First, it is important to note that TMG employs a “rules-based” approach to its tax-minimization strategy. A rules-based approach is one that applies human-made rules to algorithmic systems that are evaluating cost and pricing differences during periods of market volatility. More specifically:
- Individual portfolios and securities are monitored on a daily, weekly, or monthly basis to identify potential TLH candidates. Using TMG’s rules, this leverages an automated process at this initial level.
- TLH candidates then must meet or exceed a specific dollar or percentage minimum value to be considered further. This rule assures that potential trading costs, if any, do not detract from achieving TLH goals.
- Similar—but not identical—securities are identified to replace potential TLH candidates, assuring that a portfolio’s existing asset allocation mix and risk profile are not altered in any significant manner.
- Once approved, the TLH sale and purchase occur within 1-2 days, assuring that client portfolios retain their existing level of market exposure.
- TLH results are maintained in TMG’s portfolio management system and then reported to custodians for year-end tax reporting purposes.
Are the potential benefits of TLH substantive enough to warrant this tax optimization strategy? While results may differ based upon a client’s tax profile and other factors, both academic and financial institution studies have demonstrated an historical increase in total returns when TLH was adopted. For example, in an analysis of market returns from 1926-2018 published in the Financial Analysts Journal, researchers achieved an incremental return of 1.08% per annum with TLH.2 Over 10 years, this resulted in increased cashflow of $11,340 from a $100,000 investment, versus a portfolio of similar dollar value not using TLH.
It is important to note that many investors and advisors believe TLH is only necessary at the end of a tax year. However, an analysis completed by Vanguard1 showed that employing an annual-only TLH strategy added just 0.34% to a portfolio’s total return, while monthly TLH added 0.84% and daily TLH achieved a further increase of 0.92% in total return.
Regardless of market volatility, your financial plan plays a critical role in helping you maintain progress toward achieving your financial goals. Your trusted TMG advisor is ready to respond to any questions or concerns you might have, and to help assure that your financial plan remains both timely and actionable. Please reach out to your advisor for guidance at any time.
1 The Vanguard Group, Inc., “Tax-loss harvesting: More than a year-end tax strategy,” November 23, 2021.
2 Shomesh E. Chaudhuri, Terence C. Burnham & Andrew W. Lo, “An Empirical Evaluation of Tax-Loss-Harvesting Alpha,” Financial Analysts Journal, June 30, 2020.
Additional Sources: The Vanguard Group, Inc.; Wall Street Journal
The Mather Group, LLC (TMG) is registered under the Investment Advisers Act of 1940 as a Registered Investment Adviser with the Securities and Exchange Commission (SEC). Registration as an investment adviser does not imply a certain level of skill or training. For a detailed discussion of TMG and its investment advisory services and fees, see the firm’s Form ADV on file with the SEC at www.adviserinfo.sec.gov. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized legal, investment, accounting, tax, or other professional advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Investment involves some level of risk. Past performance is not indicative of future performance.
