Be smart about tax-loss harvesting

2023 highlighted three key principles when it comes to tax-loss harvesting:

• The importance of staying invested while tax-loss harvesting.
• The timing for unwinding tax-loss harvesting trades can be just as important as initiating them.
• Tax-loss harvesting strategies should be considered year-round to boost tax savings.

Over the last two decades, ETFs have seen tremendous growth and investor appeal. In addition to providing easy diversification and market access, ETFs are also used to facilitate tax-loss harvesting. In this strategy, an investor sells securities (stocks, bonds, or funds) that are down to realize a loss, which can then be used to offset realized capital gains and up to $3,000 of regular income. If an investor recognizes more losses than gains, or has already offset the $3,000 income cap, current rules allow for losses to be carried forward indefinitely.¹

Notably, the sale proceeds can be used to purchase ETFs with similar exposures as a way to stay invested. In some cases, investors view these positions as temporary by selling them in the following year and reverting to their original investment.

To ensure that investors don’t get a tax break and then instantly buy back their original investment, the government has what’s known as the “wash sale” rule. The rule mandates that an investor cannot claim a loss on the sale of an investment and then buy a “substantially identical” security for the period beginning 30 days before and ending 30 days after the sale.

While the practice of tax-loss harvesting may seem routine in nature, 2023 demonstrated three critical lessons when implementing the strategy:

First, 2023 illustrated the importance of staying invested after harvesting a loss. In the last two months of the year, U.S. equities returned ~14% (See figure below), an almost historic rally leading into year-end. Investors who temporarily parked assets into cash would have missed out on material gains, highlighting the importance of staying in the market.

Second, last year’s dynamic demonstrated the importance of taking broader tax implications into consideration. Investors may be surprised to learn that many investments purchased after tax-loss harvesting have seen significant price appreciation, especially in the case of U.S. equities. Unwinding these trades in 2024 may incur punitive short-term capital gains taxes, with highest marginal rates reaching more than 40%.² The timing for unwinding tax-loss harvesting trades can be just as important as initiating them.

Third, waiting until year-end to begin tax-loss harvesting can result in many missed opportunities for tax savings. U.S. equities have posted gains in 15 of the past 20 years but intra-year, have seen an average drawdown of -15%.³ Therefore, waiting until Q4 results in banking only a fraction of the offsets available to you.

As 2023 has shown, staying invested while proactively tax-loss harvesting may help lower overall tax bills and can help you be better positioned for potential rallies.