A Great Time to Talk About Tax Loss Harvesting

It’s not what you make that matters but what you keep!

This is a great opportunity to talk about tax-loss harvesting.

We’ve just experienced the fastest 30% decline from an all-time high in history. It took only 22 days. “The second, third and fourth fastest 30% declines all occurred during the Great Depression era in 1934, 1931 and 1929, respectively.” – Yun Li, CNBC

That means many investors probably now have positions with significant unrealized losses. This is a great opportunity to harvest those!

What do I mean? I mean proactively sell positions with losses to purposefully realize those capital losses, which will offset gains from earlier or later in the year. The proceeds from the sale are then used to buy something similar but different enough to avoid a wash sale violation.

Let me give you an example.

Let’s say I have a client, John. John currently has $150,000 of realized capital gains so far in 2020. That produces a large tax liability.

However, John currently owns mutual funds within his taxable account with $130,000 of unrealized capital losses.

Let’s assume I do nothing, and those mutual funds rally back to breakeven. The losses would be erased, and his investments have climbed back to his starting value. However, he still has $150,000 of realized capital gains on which we’ll need to pay taxes.

Now, instead, let’s assume I sell those positions, realize the $130,000 of losses and reinvest the proceeds in similar mutual funds. Again, assume the investments recover and claw their way back to breakeven. Since we’re investing the proceeds in similar funds he maintained the same upside exposure he had in the original funds. The difference is that now, since we proactively harvested the losses, his net capital gain for 2020 is only $20,000 (150,000 – 130,000). So his portfolio is the same value it would have been if we did nothing, but his tax liability is about $30,000 less than it would have been if we did nothing!

Note: The new investments now have short-term unrealized capital gains that will need to be managed as well, but at least we deferred the tax liability. This allows us to manage income and taxes from year to year to maximize the after-tax rate of return.

It’s worth repeating… It’s not what you make that matters but what you keep!

Investment tax management is just one more way I add value above and beyond performance and financial planning.

This approach may not be suitable for all investors. Each household has unique circumstances that impacts the appropriateness of all investment and tax strategies discussed in these commentaries.