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Tax Loss Harvesting Part I - Take the Easy Money

Everyone should do it, but few do.

Tax loss harvesting is part of any sound portfolio management plan. This piece goes over the basic concepts of tax loss harvesting and sketch the value proposition of this “easy money” strategy. 

Investing Taxable Funds, In General

Investing money outside of retirement accounts is a bit different because every sale is a taxable event that must be reported to the IRS come tax time. Brokerage accounts create interest, dividends and capital gains. If investors don’t manage the tax aspect of their portfolio, inefficient trading can create a “tax drag” that eats into overall returns. 

This is why many investors preach the “buy and hold” strategy as it results in few sales (taxable events). 

Other than being mindful of taxes, the same general investment principles apply: 

1.    Understand your risk tolerance

2.    Understand your time horizon (when you’ll spend this money)

From there, just built out a diversified portfolio of low cost, tax efficient holdings. 

Then there the only two things I recommend changing when it comes to taxable vs. nontaxable accounts:

1.    For equities, use a strategy that consistently captures tax losses 

2.    For fixed income, incorporate some municipal bonds (tax free interest—not discussed here)

The Basics of Tax Loss Harvesting 

Tax loss harvesting, at its core, is looking at all portfolio positions at some point during the year (usually the end), and selling the “losers.”

With sale proceeds, investors can either reinvest the funds in a SIMILAR (but not the same) security to maintain market exposure (you’d hate to be in cash if the market pops), or simply wait thirty days and repurchase the same stock, mutual fund or ETF. 

If the investor repurchases the security in less than thirty days after the sale/tax-loss, the IRS will disallow the prior loss under the so called “wash sale” rule.  Just know that if you sell a position for a loss, you can’t claim the loss if you buy the position back within thirty days. 

Tax loss selling is a familiar concept for many people. With this strategy it’s possible to have an overall economic gain while showing a capital loss for tax purposes. Here’s an example:

Suppose on January 1stsomeone invests $100,000 into ten securities evenly at $10,000 each. At the end of the year (12/15) seven positions are showing gains and three are showing losses. The cumulative gain on the account is $7,400, or 7.4%.  

However, if we sell every loss position, we generate a tax loss of $2,800. The proceeds of $27,200 are immediately reinvested in similar positions to maintain market exposure, but in capturing a tax loss at a federal rate of 32%, we’ve saved $896 in taxes. Here’s the visual:

 

Economic Return: 7.4%

Tax Loss: -2.8%

After Tax Return: 8.3%

Tax Alpha: $896 (0.9%)

Ok. Alpha of 0.9% might not blow you away, but small consistent positive changes create huge value over long periods of time. Over the course of twenty or thirty years, the consistent tax loss harvesting strategy can create impressive results. Even .9% every year over thirty years, cumulatively, improves a portfolio by 27%. Here’s a graph showing the above return profile for thirty years to illustrate the benefit of tax loss harvesting.

 

Some years will have better opportunities for tax loss harvesting than others. 

The Hard Part? Execution.

Like many brilliant ideas, tax loss harvesting lacks value without proper execution. Many advisors (robo and human) will preach the value of tax loss harvesting but fail to deliver. They get busy, squeamish, whatever. Last year a major roboadvisor, Wealthfront, was fined for botching this strategy.

Also, for folks with only a few positions in the account there may not be great tax loss selling opportunities (in other words, this isn't available to everyone). 

Tax loss selling is something that everyone needs to incorporate in an investment strategy for nonretirement accounts. Are you? 

Like many things, this just takes a bit of time, work and diligence. It’s “easy money” that will create value over time. 

In the next piece I’ll delve down into a more thorough quantitative strategy for folks with more than, say, $100k to invest. 

 

Disclosure:   Claro Advisors, LLC ("Claro") is a registered investment advisor with the U.S. Securities and Exchange Commission ("SEC"). The information contained in this post is for educational purposes only and is not to be considered investment advice. Claro provides individualized advice only after obtaining all necessary background information from a client. Please contact us here with any questions.

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About the Author

Robert E. Dockendorff, JD, LL.M

Robert E. Dockendorff, JD, LL.M

Robert Dockendorff is a Vice President of Claro Advisors, LLC. Bob serves as an Advisor at Claro, where he helps clients achieve financial goals through careful analysis and the development of long-term plans that encourage consistent, achievable actions. Bob also enjoys sharing helpful financial planning insights on his blog and is an active contributor on Investopedia's Advisor Insights website.

Prior to joining Claro, Bob was a Senior Associate Financial Counselor at The Colony Group, supporting a team of financial counselors with research and analysis on all areas of wealth management and financial planning for high net worth individuals. He also focused on the implementation of investment, estate, and tax planning tailored to the specific goals of diverse clients. Prior to joining The Colony Group, Bob worked as a Tax Associate at the international accounting firm Ernst & Young, where he conducted tax research for multi-national businesses. Bob received a Bachelor of Arts in Philosophy from the University of Vermont. After college, Bob earned a Juris Doctor from Suffolk University Law School, Cum Laude, and an LL.M in Taxation from Boston University Law School. Bob has previously passed the FINRA Series 65 and the MA Life and Health Insurance Producer Exam. In his spare time, Bob enjoys the mountains, the beach, and playing golf. Bob resides in Hingham, MA with his wife Caitlin and two sons, Charlie and Tommy.

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Disclosure: Claro Advisors LLC ("Claro") is a Registered Investment Advisor with the U.S. Securities and Exchange Commission ("SEC") based in the Commonwealth of Massachusetts. Registration of an Investment Advisor does not imply any specific level of skill or training. Information contained herein is for educational purposes only and is not to be considered investment advice. Claro provides individualized advice only after obtaining all necessary background information from a client. This report is not a financial plan and is not intended as a solicitation or advice to purchase specific investments, but the information provided can assist you in evaluating your current financial situation and your ability to achieve your investment goals. Any projection of investment outcomes is hypothetical in nature, does not reflect actual investment results, and is not a guarantee of future results. Similarly, other information regarding various investment outcomes are hypothetical in nature, do not reflect actual results and are not guarantees of future results. The projections may not include all taxes applicable to your situation. Past performance is no assurance of future results. Investments may fluctuate and lose value, and unexpected market movements may result in changes in rates of return and anticipated performance. Claro does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation. Claro will provide all prospective clients with a copy of our current Form ADV, Part 2 ("Brochure") prior to commencing an Advisory relationship. Please contact This email address is being protected from spambots. You need JavaScript enabled to view it. or toll free at 800-604-2838 with any questions.

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