Let’s Talk About Taxes … And Tax-Loss Harvesting

It is one of investors’ least favorite times of the year – tax season. That imminent tax bill is due in about two weeks, so it is a good time to discuss tax relief strategies. Depending on the size of an investment portfolio, a tax-loss harvesting strategy and ETFs could help investors keep a few percentages more of what they make.

Tax-loss harvesting allows investors to sell securities that experienced losses in order to offset taxes on other winners. As an example, let’s discuss a hypothetical portfolio with two holdings: Security X and Security Y. Let’s assume Security X increases by $1,000 in value, while Security Y decreases by the exact same amount. If you sell both securities, you will be exempted from capital gain taxes – the loss in value of Security Y offsets the increase in value of Security X.

The IRS prevents investors from selling the losers to offset taxes on the winners through a “wash rule.” One can’t claim a loss on a stock to offset taxes on a gainer if he or she bought a similar security within 30 days before or after the sale.

Tax harvesting is a useful strategy if one was already planning to exit an underperforming position. But even if the tax relief from the sell is significant, it is perhaps even more important to stay focused on the overall investment strategy. Here is where ETFs could help maintain the initial portfolio allocation and risk profile while getting the benefits of tax harvesting.

To better explain how an ETF could help, let’s look at a much-discussed sector: energy. The sector had a very rocky 2014. Oil dropped, and many energy stocks tanked. Those with a significant exposure in energy securities were hit hard. Even a few billionaires (especially Carl Icahn) were affected by the sector’s turbulent year. Let’s assume an investor with a position in energy could sell the security to offset gains on a different winning stock. But, he believes the sector will rebound, so he wants to keep his energy exposure going forward. However, the IRS wash rule prevents him from buying a similar energy stock if he wants to claim the loss for tax purposes. An energy ETF could come in handy. The ETF could replace his energy position, while maintaining his exposure to the energy sector and complying with the wash rule.

Similarly, inventors can replace ETFs that lost value with secondary ETFs that track different indices of the same asset class. With over 1,500 ETFs available, finding a replacement is no longer a challenge.

The tax relief from tax-loss harvesting will mostly depend on the size of an investment portfolio. Previously, the strategy was only available to high net-worth individuals with more than $5 million in assets. Today, automated investment advisors such as Betterment and Wealthfront make the strategy available to individuals with just $50,000. The tax-harvesting tool runs daily and scans eligible portfolios for securities that lost value. Then it automatically sells those positions and replaces them with similar ETFs to maintain the client’s desired risk profile. Wealthfront’s research shows tax-loss harvesting could increase an investor’s after-tax returns by as much as 2% per year.

Another potential benefit of an automated system in tax harvesting is the lack of emotions. The algorithm will sell the security and replace it automatically without giving it too much thought. A financial advisor might wait to see if the stock rebounds – it is a fundamental rule of investing, after all. But if the position does rebound, the potential benefit from harvesting is lost. So, it is important to harvest throughout the year and not only in Q4.

Investors should certainly use all the tax relief strategies they qualify for. No one likes taxes after all. But in investing, staying focused and balanced is perhaps even more important than saving an extra 2% of your returns. So, knowing how to maintain your desired portfolio allocation and risk profile while getting the benefits of tax harvesting is imperative.