When Tax-Loss Harvesting Makes Sense (And When It Doesn’t) (EP.162)

0:28We all need to make smart decisions with our money. many believe is a must-do for every investor, and that's tax-loss harvesting. But what if I told you that this widely recommended tactic might not be beneficial for everyone? While tax-loss harvesting has the potential to improve your after-tax returns, its effectiveness heavily depends on your personal financial circumstances and how you execute the strategy. But before we dive too deep, let's do a quick level set with the basics. If you're not familiar with tax loss harvesting, it's simply an investment strategy used to convert investment losses into tax savings.

1:10Here's how it works. When you sell a security at a loss, you can use that loss to offset capital gains and up to$3 ,000 of ordinary income each year. Now, if your losses exceed your gains plus$3 ,000, you can also carry forward those capital losses to future years. So imagine your portfolio experiences a$3 ,000 loss. You sell the position, realizing the loss, and then use it to offset the income, saving$900 in taxes. Sounds great, right? But here's where it gets interesting. The value derived from tax loss harvesting hinges on three foundational components. Generating losses, converting those losses into tax savings and reinvesting the tax savings.

2:00And each of these steps is influenced by a variety of factors like market volatility, your tax rate, your ability to reinvest effectively. And I think before we can even really talk about the quantifiable value of tax loss harvesting, we need to understand these different components and their relative importance to the value of tax loss harvesting. There is newly published research from Vanguard that I'll link to in the show notes at thelongterminvestor.com that models out the relative importance of the underlying factors to generating losses, converting those losses into tax savings, and reinvesting the tax savings.

2:38And the first component is the ability to generate losses. And there are five critical factors that influence this. The first and most important to your ability to generate losses is volatility. Securities that experience significantly higher short-term volatility are prime candidates for tax-loss harvesting because the price swings can push the value of these securities below their purchase price, creating those harvesting opportunities. According to Vanguard's research, volatility accounts for about 17 % of the relative importance to getting the full value of tax-loss harvesting. Next is harvest frequency, which is just how often you monitor and harvest losses.

3:22So if you're regularly checking your portfolio for loss opportunities, it typically means you can capture more losses. And studies have shown that frequent harvesting, such as daily or monthly checks, can significantly enhance tax loss harvesting outcomes. The third one is recurring investments. So new investments represent new tax lot harvesting opportunities. And by continuously adding new investments to your portfolio, you can create more chances for their value to dip below the cost basis, thus enabling further harvesting. Now, the relative importance of this one is 2%. I'm realizing I forgot to tell you that the harvest frequency had a relative importance of 7%.

4:01And as I already mentioned, volatility had a 17 % on relative importance. The last two are portfolio granularity and time horizon. Portfolio granularity has relative importance of 3%. And this is really just saying that the more granular your portfolio, the more diverse and spread out your holdings are, and the higher the chances are of finding individual securities with losses. So direct indexing, for example, where you own the individual securities within an index rather than a single fund, that can be something that increases the lost harvesting opportunities. Or instead of owning the total U.S.

4:40stock market in a single ETF, perhaps you own a large cap, a mid cap, and a small cap, or a large cap in a completion index. Those different funds give you more opportunities to harvest. And the last one is time horizon, relative importance of 2%. The longer you invest, the more opportunities you have to harvest losses as markets fluctuate. And so over extended periods, various securities in your portfolio will inevitably experience downturns presenting these lost harvesting chances. So those are the factors that make up generating losses. I'm going to have a table of all these at the show notes at the longterminvestor.com.

5:19As we transition into the second component, which is converting those harvested losses into actual tax savings. And this depends on your tax situation and how effectively you can utilize those losses. So the biggest factor, and actually the single biggest factor across all of the factors and drivers, is your current and future tax rates with a relative importance of 27%. So this is pretty intuitive. The higher your tax rate, the more valuable the tax savings from harvested losses. And if you're currently in a high tax bracket, offsetting gains in income can significantly reduce your tax liability.

5:58Conversely, if you expect your tax rate to increase in the future, deferring those tax savings until then can amplify their value. The second piece to the conversion to tax savings is loss offsetting income, which has a relative importance in the Vanguard study of 5%. because besides offsetting capital gains, up to$3 ,000 of ordinary income can be offset annually using harvested losses. And this provision is particularly beneficial if your capital gains aren't sufficient to absorb all your losses in any given year. Now, the last component, this third component, is the reinvestment of tax savings into the market.

6:37And this step is crucial because it leverages the power of compound growth to enhance the overall return on your portfolio. So the factors influencing this are just the simple reinvesting of your tax savings, which had a relative importance of 25%. So that's the second biggest number. And I actually think it's pretty important because I don't think most investors do this. And just to make sure we're all on the same page here, reinvesting the tax savings back into your portfolio, it ensures your capital continues to grow. And historically, the stock market has appreciated over time. But I'm just not so sure how many people are looking at the tax savings from the strategy and making an additional contribution to the portfolio.

7:22And given that that's 25 % of the relative importance, keep that in mind when I start talking about the actual value that Vanguard found in tax loss harvesting. The other component here of market exposure is just the market return. Vanguard gives its relative importance a 12%. And this makes sense. The success of tax-lost harvesting, if you're going to be adding capital, is going to depend on the market's performance because in a rising market, the benefits of reinvested tax savings are amplified. So I think all these things that I've listed out, again, I'll have a table of it in the show notes at thelongterminvestor.com.

7:58When you understand how these components interact with each other, you can start to tailor your tax-loss harvesting strategy to your unique circumstances. For example, an investor in a high tax bracket with a volatile portfolio and a long investment horizon stands to gain significantly from tax-loss harvesting. On the other hand, a passive investor with a low tax rate and minimal capital gains might find it less beneficial. In short, the effectiveness of tax-loss harvesting is highly personalized. And it's not just about harvesting losses, it's about how those losses are generated, converting them into tax savings and reinvesting them to maximize growth.

8:42And that brings us to the question, if you're doing all these things, what is the actual value of implementing an optimal tax loss harvesting program? Well, according to this newly published research from Vanguard, the excess annual return achieved by conducting an optimal tax loss harvesting program ranges from 0.47 % to 1.27 % depending on net worth in tax brackets. And so for context, the profile of an investor at the top of that range has a net worth of at least two and a half million and is assumed to be a California resident in the top tax bracket, which translates into a total ordinary income tax rate of 48.3 % and a long-term capital gains tax rate of 31.3%.

9:31So that's the very top end of the range. At the lowest end of the range, the 0.47 % of excess annual return achieved by conducting an optimal tax-lossed harvesting program was an investor with a net worth between$659 ,000 and$1.6 million, along with an ordinary income tax rate of 22 % and a long-term capital gains rate of 15%. Now, what Vanguard's research uses in its modeling for optimal tax-loss harvesting behavior includes harvesting losses daily, reinvesting all tax savings, making quarterly contributions to the portfolio, and harvesting in a direct indexed portfolio. A suboptimal tax-loss harvesting program in Vanguard's research involves quarterly lost harvesting, reinvesting half of the tax savings, no ongoing cash contributions, and investing in commingled funds exclusively, like an ETF or a mutual fund.

10:32And in this scenario, the range of excess returns was only 0.04 % to 0.13%. So a few things stand out to me. First of all, you need to have a decent-sized net worth and marginal tax bracket to derive enough value from the tax lost harvesting to make the juice worth the squeeze. Second, and I think this is a big one, the difference between what Vanguard defines as optimal versus suboptimal tax lost harvesting is stark. I mean, the excess returns from the suboptimal tax lost harvesting are so small that I would question if it's even worth doing. So, I mean, unless you're really going to do this tax loss harvesting thing right, why even bother?

11:17That's what I'm seeing in this research. And that's what I want to focus on from here is how to do it right. So again, let's compare the differences between the optimal and suboptimal tax loss harvesting in this study. And as I read these to you, ask yourself, are you closer to the optimal version or the suboptimal version? And if you're closer to the suboptimal version, are you better than it or worse than it? So four things. Daily versus quarterly tax loss harvesting, daily being the optimal. Reinvesting 100 % of the tax savings versus only 50 % of the tax savings. Quarterly portfolio contributions versus no portfolio contributions.

12:03investing in a direct indexed portfolio versus investing only in commingled funds. Again, if your tax loss harvesting is suboptimal or worse, perhaps that's a case for using a financial advisor or just not doing it at all. Don't get me wrong, I think tax loss harvesting is really valuable when done correctly, but you do have to understand the drivers of that value and the potential risks. And that helps you make informed decisions and maximize your benefits. And remember, the most critical factor, the one that I think a lot of people are leaving out, is to reinvest your tax savings in the portfolio to realize this full potential tax loss harvesting.

12:50If you're finding this episode insightful, do go visit the show notes at thelongterminvestor.com. download the original Vanguard paper, and dive deeper into the details. Really see where some of these differences lie. And don't forget to leave a review on your preferred podcast platform. Not only does your feedback help us improve and reach more listeners, but let me know what you're thinking about your own tax loss harvesting program. As always, thanks for listening. And until next time, to long-term investing. Thanks for listening to the Long-Term Investor podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com.

13:33Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.