The end of the year generally sees a flurry of activity within the ETF space as advisors and investors move in and out of funds while looking to maximize their tax-loss harvesting. This year is proving to be no different, and the Wall Street Journal ran some simulations to discover just how much can be saved within portfolios utilizing this method.
Tax-loss harvesting is the practice of selling assets and stocks whose value has fallen and using those losses to offset the tax liability attached to capital gains. This method reduces the overall tax burden of a portfolio come tax time, and at the volatile close of a year that has seen record equity performances, the potential to capture greater losses has ETF trades on the rise for the month.
Through simulations that covered a variety of portfolio sizes, tax brackets, and holding periods, it was discovered that investors with a capital gains tax rate of 25% can increase their portfolios’ annual returns by 1.1–1.42% by using tax-loss harvesting. These numbers are estimated based on steady market performance; in the midst of volatility, the potential is greater because stocks could potentially lose more, thus offering greater balance for capital gains.
Higher returns are also possible when capital gains tax rates are higher, due to an investor selling short-term holdings within their portfolio or because of higher interest rates from the government.
The simulations were built using data going back to the 1930s from the NYSE, Nasdaq, and the old American Stock Exchange. Portfolios were created that were value weighted to duplicate the typical investment practices of most investors and were run through a variety of market conditions.
The 1.1% increase was based on conservative estimates, and the 1.42% increase was based on maximum tax-loss harvesting opportunities utilized. Both stem from steady market conditions, but in down years of market performance the losses harvested could amount to as much as a 3.21% return increase.
In years of above average market volatility, investors could gain 2.22% on average, and low-volatility years yielded just 0.95% in returns gained. All were based on a tax rate of 25%.
American Century Investments underscores that times of volatility provide excellent opportunities for tax-loss harvesting in a paper. ETFs are known for their tax efficiency and trading flexibility, and for these reasons they make excellent vehicles for tax-loss harvesting.
When considering tax-loss harvesting, it’s important to understand the wash sale rules, which basically mean that an investor can’t sell a security and then turn around and either buy it back or buy a “substantially identical” one within 30 days without incurring tax penalties, according to American Century.
“Something to watch: the tax loss harvesting flows usually pump up December beyond monthly average,” tweeted Erich Balchunas, senior ETF analyst for Bloomberg. Balchunas went on to predict that seeing $6 billion per day in flows is not unthinkable when driven by tax-loss harvesting movement.
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