Tax-loss harvesting: Volatility’s silver lining?

AS UNPLEASANT AS ONGOING VOLATILITY CAN FEEL, investors may find ways to turn choppy markets to their advantage through a process known as tax-loss harvesting. Simply put, tax-loss harvesting means taking losses on investments that have declined in value in order to offset capital gains taxes you may owe on investments you sell that have increased in value.

That tactic has become increasingly relevant in today’s markets. “During periods of heightened volatility, there is greater opportunity to systematically harvest losses,” says Mitchell Drossman, head of National Wealth Strategies in the Chief Investment Office (CIO) for Merrill and Bank of America Private Bank. If your capital losses for the year exceed your capital gains, you may also be able to apply up to $3,000 of losses against wage income or investment income. Another advantage: “If you decide not to use those losses to offset gains or income this year, you can carry them forward indefinitely for federal tax purposes,” Drossman says. (State tax rules may vary).

Despite these advantages, tax-loss harvesting, like any investment strategy, does entail some risks. “Selling investments to harvest losses takes those assets out of the market, leaving you less exposed to potential gains if markets rebound,” notes Joseph Curtin, Head of CIO Portfolio Management for the Chief Investment Office. A recent Educational Series report from the CIO, “Tax-Loss Harvesting and Personal Indexing: An Effective Portfolio Strategy During Volatile Market Environments,” details how harvesting works, what regulations govern the process and why a careful, systematic approach may be best. See a few of the highlights below:

Avoid triggering a wash sale

To ensure that losses actually count as deductions, it’s important to understand the IRS’s Wash Sale Rule, prohibiting deductions for investors who sell securities for a loss and repurchase the same or “substantially identical” securities 30 days or less before or after the sale. “The rationale is to prevent people from declaring a current loss when the sale and repurchase are so close that they haven’t really changed their position,” Drossman says.

The Wash Sale Rule applies even if the repurchase occurs in an account owned by your spouse, or by a corporation you control, Drossman notes. A wash sale could even happen inadvertently. “If you have two accounts, and the manager of one sells a certain stock to harvest a loss, while the second manager buys the same stock within 30 days, that’s a wash sale.”

Look into direct indexing

To simplify the process and lessen the chances of a wash sale, some investors may consider “direct indexing” — an investing strategy that involves working with your advisor or fund manager to invest in a portfolio of stocks that closely tracks the performance of an index such as the S&P 500. At the same time, the portfolio is customized to reflect various preferences. Among the most popular options is tax efficiency. For investors who select that preference, “stocks that decline in value are periodically sold to harvest losses, while the overall portfolio continues to track the index,” Curtin says. “Those harvested losses can be used to offset capital gains at tax time and potentially help you keep more of your returns,” he adds.

One traditional drawback to direct indexing has been the high investment minimum of $100,000 or more. “However, with the adoption of fractional share trading, some providers are bringing down their investment minimums,” Curtin adds. And because these portfolios replace harvested losses with stocks purchased at reduced prices, they tend to have a low cost-basis.

Consider gifting stock

While tax-loss harvesting may help make your portfolio more tax-efficient, taxes are only one of many considerations when managing your portfolio during volatile markets. Gifting is another area where volatility can provide a tax advantage. Say, for example, you are interested in making a gift of stock to heirs but want to ensure the total, in dollars, doesn’t exceed your gift tax exemption. Temporarily depressed share prices could enable you to give more shares than you would if the price were elevated, while still staying under the exemption amount, Curtin notes. And, should the price rebound in your heirs’ possession, they could benefit from having received more shares and a larger gift.

At the end of the day, “it’s important to make any of these decisions within the context of your long-term investing objectives and personal goals and as part of a balanced, diversified portfolio,” Curtin says. Speak with your financial advisor and tax professional to see whether tax-loss harvesting might be appropriate for you.