With the stock market down about 25% from its high, it’s an ideal time to execute some tax-loss harvesting strategies. Tax-loss harvesting is the practice of selling a security that has experienced a loss. By realizing, or “harvesting” a loss, you create a tax-loss carry forward which can be used to offset future gains or income. In effect, tax-loss harvesting, when done correctly, can lower future tax liability without changing your target allocation or expected returns. In this article, we’ll discuss why now is an ideal time to harvest tax-losses and how we’re executing the strategy for clients.
Tax-Loss harvesting doesn’t need to wait
The most popular time to begin tax-loss harvesting is near the end of the year. But there’s no rule against doing it whenever you want. And in practice, the best time to harvest your losses is when they are the biggest, as that creates the greatest tax-loss carry forward possible. So with most major indices in the US and abroad all down more than 20%, now is a great time to take some losses.
If you wait until the end of the year, market indices may have recovered, nullifying the benefits of tax-loss harvesting. What if you tax-loss harvest now, and the market keeps going down? Well, there’s nothing stopping you from tax-loss harvesting again at a later date. Just make sure you wait at least 30 days to avoid any Wash Sale violations.
Index funds make tax-loss harvesting easy
We are big proponents of using market index ETFs for many reasons. And one of those is how valuable they are for tax-loss harvesting purposes. Because there are so many competing market index ETFs to choose from, we can easily swap one out for another. Here are some real-life examples of tax-loss harvesting trades we’ve executed recently:
- Sold SCHV at a loss to buy IWD. These are both large-cap value ETFs with 71% fund-overlap, which is a little lower than we’d prefer (they’re not identical). However, each issuer has a slightly different take on large-cap value and there was no “perfect match.” We chose IWD due to its low expense ratio (0.19%) and massive liquidity ($29.5 billion in AUM + $341 million in average daily trading volume). In addition, IWD makes for an efficient pairing with its large-cap growth ETF counterpart, IWF, which we also own for clients.
- Sold IJR at a loss to buy VIOO. Both of these ETFs track the S&P 600 small-cap index. Together, they own 98% of the same holdings, making them a near-identical match. So this was an easy decision and we’re really not sacrificing anything in the way of target allocation or expected returns.
- Sold IJH at a loss to buy IVOO. Both of these ETFs track the Mid-Cap 400 index. Together, they own 99% of the same holdings. Similar to our small-cap ETFs, this was an easy allocation to be able to replicate.
What goes into each decision
There are three main factors that drive our decision-making process when it comes to tax-loss harvesting. They are:
- Are current losses in taxable accounts big enough to create a worthwhile tax-loss carry forward? In the “bad problem to have” category, the answer is yes.
- Can we easily buy new index funds that will efficiently replace the ones we are selling? As outlined above, yes. There are so many competing low-cost funds all tracking the same index, that it makes this part pretty easy. ETF.com is a great website to use to find similar funds.
- Can we use current losses to cancel out unrealized gains? Imagine a scenario where you’ve held a security for years and have substantial gains, but you’ve been hesitant to sell it because you don’t want to trigger a large tax obligation. Well, if you have current losses to offset those gains, tax-loss harvesting is a great time to sell a profitable position too. Then you can rebuy the profitable position right back. In effect, this eliminates your tax liability (because of the losses you also took), and raises your cost basis (when you rebuy the position back).
- If doing this, make sure you are buying back the same security you sold for a profit. If you sell and rebuy the same security you’re taking a loss on, you will trigger a Wash Sale violation. Additionally, we recommend buying back the profitable security immediately to keep your new cost basis as close as possible to your sale price (i.e. don’t try to time a pullback by selling on Friday and planning to buy back next Tuesday).
Tax-loss harvesting is a value add
No one wants to see their investments go down in value. But tax-loss harvesting can be a value add, that, when done correctly, better positions your portfolio for brighter days ahead. You don’t need to wait until the end of the year to practice tax-loss harvesting. And market index ETFs make the practice easier than ever. The benefits can include generating a valuable tax-loss carry forward or lowering current tax obligations. Reach out to us if you’d like to discuss tax-loss harvesting strategies in your portfolio.
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