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Tax-aware investing and systematic tax loss

Harvesting in a higher capital gains rate regime

INSIGHT ARTICLE  | 

Tax-aware investing and active tax management have long been hallmarks of our investment approach. Under the Biden administration’s proposed tax plan, federal capital gains and qualified dividend tax rates would increase from 20.0% to 39.6% for households with Adjusted Gross Income above $1 million (plus the 3.8% Affordable Care Act [ACA] surcharge). The ultimate rate and effective dates of any changes are still unclear with the political process still playing out, but directionally the push is for higher capital gains rates. In that environment, careful planning and active tax management strategies are even more critical as part of a successful investment plan.

The investment playbook in a higher capital gains rate environment places a greater emphasis on many familiar strategies, including:

  • Active tax loss harvesting (TLH)
  • Thoughtful asset location: allocating higher turnover active managers with higher capital gains potential in tax-advantaged accounts; investing in municipal securities and other tax-advantaged assets
  • Charitable gifting of appreciated securities
  • Proactive timing of gain recognition to stay below higher income thresholds, if possible
  • Consideration of variable annuities

Near-Term Considerations

Implementation timing of certain strategies is clouded by the uncertain magnitude and timing of law changes. For example, accelerating capital gains recognition before a potential law change has appeal, but may be less effective if rates do not change or if changes are retroactive. Time horizon and future expected returns on investments also influence what might be the proper course of action. Likewise, delaying tax loss harvesting into the following year when the losses could be more valuable may make sense, but only if tax law changes pass and rates increase. In addition, market appreciation may reduce or even eliminate loss-harvesting opportunities, negating the benefits of waiting. Such nuances make it important to speak with your advisor about scenario analysis and long-term plans under various tax regimes.

Ongoing Considerations

Setting aside near-term timing considerations, let us focus a bit deeper on proactive, ongoing tax loss harvesting. While hoping for investment losses may be counterintuitive, normal market volatility, plus business and economic cycles, mean that even successful long-term investments may have periods of negative performance. Recognizing (harvesting) those losses and reinvesting the proceeds can create a tax-loss asset that can be used to offset realized capital gains.

Those losses are more valuable in a world where capital gains rates are considerably higher. Under the current proposal, every dollar of loss harvested represents 39.6 cents in federal tax savings versus 20 cents currently (ignoring the 3.8% ACA surcharge).

Historically, TLH has been a calendar or tax year exercise for many (i.e., as year-end approaches, investors assess capital gains and look for possible offsetting losses). However, market volatility can create TLH opportunities intra-year as well. For example, while broad global equity markets posted positive returns in 2020, the sharp sell-off in March provided meaningful opportunities to harvest temporary losses. Even in years without a meaningful market pullback, opportunities can still be plentiful, as we discuss below.

Investment Vehicles

For mutual fund and exchange traded fund (ETF) investors, whose investments in a given market or asset class are pooled into a single vehicle, TLH opportunities are limited to broad market declines or declines in sub-asset classes (i.e., small cap equities, emerging markets). Mutual fund managers may harvest tax losses in their portfolios, but those losses may only be used to offset gains in the fund; net realized losses may not be distributed for investors to use against gains elsewhere in their portfolios.

However, with separately managed accounts of individual securities and, more specifically, in systematic strategies focused on TLH, investors may benefit from the dispersion in returns across stocks (or bonds). That is, even though a broad market index might have a positive return, some component stocks will almost certainly have negative returns, while others have correspondingly positive returns over a given month, quarter or calendar year. This dispersion provides tax loss harvesting opportunities. For example, in 2020, the S&P 500 Index returned 18%. At the same time, 172 companies had negative returns for the year and 50 declined 20% or more. Through Q1 2021, while the Index was up 6%, 105 stocks were down, with 12 down 10% or more. Even in 2017, a year characterized by low volatility and steadily rising stock prices, 89 S&P 500 Index components posted a negative price return for the year, with the 10 worst performers down an average of nearly 36%.1

Consequently, systematic TLH that looks across a broad portfolio of individual securities on an ongoing basis can take advantage of opportunities created by market volatility and price dispersion, creating a tax benefit while maintaining market exposure. Many studies suggest that consistent stock-picking outperformance (alpha) is hard to come by, but dispersion and market volatility are characteristics of markets that make tax alpha one of the more persistent sources of potential excess return versus a fully passive approach.

As noted above, higher capital gains rates make TLH more valuable; however, the ultimate “tax-alpha” generated by a systematic TLH strategy fluctuates over time. It is a function of several things, including the tax rate, overall market volatility, volatility of the individual stocks in a portfolio, expected or realized return on investments, and the cost basis in the portfolio relative to the market value.

In the chart below, provided by Parametric, we show the expected range of tax alpha in a variety of tax regimes and for a variety of market returns in a typical stock-volatility environment2. The average stock volatility was varied in the simulation as well. This example focuses on the midpoint volatility of 35% (see research brief A Malarkey-Free Analysis of the Impact of the Biden Tax Plan on Equity Investors | Parametric Portfolio for further details). Higher tax rates and the loss of preferential treatment for long-term holdings resulted in an estimated incremental benefit of roughly 0.40% in the Biden proposal versus the current environment.


Source: Parametric, 2021. Tax alpha is the difference between a portfolio’s after-tax excess return (net of fees) and its pretax excess return (gross of fees). A portfolio’s excess return is the difference between the portfolio’s return and that of its benchmark. Simulated results are hypothetical and are provided for illustrative purposes only. They do not reflect the experience of any investor and should not be relied upon to make investment decisions. These results do not reflect or estimate the performance of any strategy offered by Parametric. Simulated returns reflect the reinvestment of dividends and other earnings and include the deduction of advisory fees (0.35%) and transaction costs (0.10%). Tax alpha is the difference between a portfolio’s after-tax excess return (net of fees) and its pre-tax excess return (gross of fees). A portfolio’s excess return is the difference between the portfolio’s return and that of its benchmark. See Disclosures for simulation methodology and additional information.


Current versus Future Tax Benefits

One key point is that the simulation above reflects the ongoing, pre-liquidation benefit of tax loss harvesting, which is higher under the Biden proposal. The end game, or post-liquidation impact, will be largely determined by the outcome of negotiations around the step-up in cost basis upon death. All else equal, tax loss harvesting generates current tax benefits, but increases potential future tax liability. This is due to the fact that by selling securities and reinvesting the proceeds, the investment cost basis is reduced.

Take this simple example:

  • Invest $1,000 in an ETF (market value = cost basis, $0 gain/loss on day 1).
  • The fund value subsequently declines to $900 and the $100 loss is recognized/harvested.
  • Re-establish the position in a similar, yet differentiated investment3, with $900 proceeds. The new cost basis is now $900.
  • ·The ETF’s market value then increases to $1,100. The new unrealized gain is now $200 versus $100 if there was no tax loss harvesting.

This basis erosion accelerates with more frequent TLH or in the case of a systematic TLH separate account versus a mutual fund or ETF. If the current basis step-up provisions are eliminated, and capital gains tax rates are higher, that future tax liability is both larger and (short of large charitable donations) very difficult for heirs to avoid. The elimination of step-up would reduce the incentive for the owner to continue deferring gains, at least if the investor thought there would not be any future reversal of such a policy. Accordingly, it is advisable to speak with your Advisor to evaluate the impact of TLH and deferral of gains based on your unique situation.

Conclusion

Tax management/awareness has always been a critical component of effective portfolio construction and management. In a regime of higher capital gains rates, a focus on after-tax returns is even more critical. Our tools, technology and access to specialized tax-managed strategies can help clients navigate the changing environment and mitigate some of the impact of potential tax law changes on their portfolios. We look forward to helping you achieve your goals.


1Source: FactSet.
2Based on 10,000 simulated trials of optimized large-cap portfolios against a low-turnover benchmark, rebalancing quarterly over 10 years.
3In order to avoid violating wash sale rules, an investor must wait at least 30 days before purchasing essentially the same security.

This document contains general information, may be based on authorities that are subject to change, and is not a substitute for professional advice or services. This document does not constitute audit, tax, consulting, business, financial, investment, insurance, legal or other professional advice, and you should consult a qualified professional advisor before taking any action based on the information herein. Information has been obtained from a variety of sources believed to be reliable though not independently verified. RSM US LLP, its affiliates and related entities are not responsible for any loss resulting from or relating to reliance on this document by any person. Internal Revenue Service rules require us to inform you that this communication may be deemed a solicitation to provide tax services. This communication is being sent to individuals who have subscribed to receive it or who we believe would have an interest in the topics discussed. Past performance does not indicate future performance. The sole purpose of this document is to inform, and it is not intended to be an offer or solicitation to purchase or sell any security, or investment or service. Investments mentioned in this document may not be suitable for investors. Before making any investment, each investor should carefully consider the risks associated with the investment and make a determination based on the investor’s own particular circumstances, that the investment is consistent with the investor’s investment objectives.

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