Tax-loss harvesting: Upgrade portfolios amidst volatility

A potential silver lining to the challenge of recent market volatility is the opportunity to gather tax benefits through tax-loss harvesting. This strategy can be implemented throughout the year (not just at year end) and is particularly relevant in today’s market environment.

What is tax-loss harvesting?

Tax-loss harvesting is a strategy of selling investments at a loss in order to lower taxes. Losses are typically used to offset gains, such as those from sales of investments or capital gains distributions from mutual funds, closed-end funds, or ETFs. For many investors, tax-loss harvesting is a critical tool for reducing their overall taxes. It is also typically part of a broader tax management strategy—since taxes are often the largest cost faced by investors, delaying tax payment keeps more assets available to grow.

The opportunity: Benefits of tax-loss harvesting

Lower taxes and enhance portfolio’s long-term value

In the short-term, the primary benefit of tax-loss harvesting is lowering capital gains tax liability [Exhibit 1]. Lowering taxes, in turn, has successive long-term benefits. Consider a portfolio without any tax-loss harvesting. Typically, any taxes paid on gains will come from the portfolio, which reduces after-tax return. Utilizing losses to offset gains, however, minimizes taxes and leaves more assets in the portfolio, allowing a compounding effect to drive long-term wealth accumulation.

Use volatility to upgrade portfolios

Although we may prefer for all markets to rise, there are always investments that decline in price regardless of the broader market environment [Exhibit 2]. Tax-loss harvesting allows investors to harness this naturally occurring market volatility to their advantage by using price dips to harvest losses and enhance after-tax return. Normally low return years provide more harvesting opportunities than high return years, but the strategy is relevant throughout market cycles since losses exist in all markets. Additionally, investors who harvest losses as they become available throughout the year (rather than waiting until year end) may benefit from having more opportunities to harvest losses.

Rebalance portfolios with flexibility (but beware of wash sales)

After selling a position at a loss, investors have the opportunity to reinvest the proceeds in a similar asset to maintain their portfolio’s asset allocation and expected risk and return levels. In doing so, they must take the “wash sale” rule into consideration. This Internal Revenue Service (IRS) rule mandates that an investor cannot claim a loss on the sale of an investment and then buy a “substantially identical” security within 30 days before or after the sale. The rule prevents people from selling securities at a loss and then immediately buying them back just to get a tax benefit—in short, from gaming the system. Unfortunately, the IRS does not offer a precise definition of what constitutes a substantially identical security. The definition of “substantially identical” depends on the situation and is subject to interpretation. To avoid inadvertently triggering a wash sale when reinvesting proceeds in a similar investment, investors should consider the degree of holdings overlap and degree of difference in prospective returns between the two investments. Common replacements that are generally not considered substantially identical include two mutual funds, closed-end funds, or ETFs tracking the same benchmark but managed by different advisors, or two investments within a similar industry. However, exceptions exist so investors should always consult with a tax professional as to their own facts and circumstances to consider their options.

Successful tax-loss harvesting requires a diligent approach

Selling positions with losses is not without risk. In some cases, short-term tax benefits do not outweigh missing out on a future recovery. Tax-loss harvesting requires a systematic approach which takes into account an investor’s broader tax management strategy and most importantly, overall investment strategy. At Nuveen, harvesting losses is an integral part of managing investment portfolios. Our investment team is consistently seeking opportunities to improve the positioning of our portfolios across markets. When executed successfully—particularly during times of volatility—tax-loss harvesting becomes an important driver of investment success.