What is tax-loss harvesting? In short, it’s a tax-efficient investing approach that involves selling selected investments from a portfolio at a loss to help offset the negative tax impact from other holdings that are sold at a profit and therefore generate taxable capital gains. Eligible investments aren’t limited to stocks or stock funds; losses from bonds and other asset classes can be used to offset gains as well.
For investors in mutual funds or exchange-traded funds—as opposed to individual securities—capital gains are triggered as portfolio managers sell holdings that have appreciated in value, based on the difference between the purchase price and subsequent sale price. The fund’s shareholders share the tax burden in the same calendar year that the net gains were realized.
Tax-loss harvesting applies only to assets held in taxable accounts; in other accounts such as IRAs and 401(k)s, assets grow tax deferred1 and aren’t subject to capital gains taxes in the year they occurred. The tax impact can be especially big for taxable account holders with high incomes that place them in the three top-tier tax brackets paying rates of 32%, 35%, and 37%.
Finding a potential upside in a bear market
The possibilities from tax-loss harvesting became more plentiful as the S&P 500 Index entered a bear market on June 13, when its decline from a record high achieved on January 3, 2022, exceeded 20%. As a result, investors have more equity holdings in their portfolios that have generated losses, making them potential candidates to sell to help offset potential gains from other holdings that have appreciated. A similar opportunity arose the last time the S&P 500 fell into bear territory in February 2020 in the early days of the pandemic. (That bear market was brief, lasting just over a month before a rapid recovery rally triggered a new bull market.)
In contrast, there have been relatively few tax-loss harvesting opportunities in recent history, as equities have generated positive returns in most years. Since 2009—the last year of the global financial crisis—the S&P 500 has finished in positive territory 10 out of 13 years; going back to 2003, it’s been positive 15 of 19 years.2 Coming after the stock market’s positive performance in 2019, 2020, and 2021, there’s a high likelihood that current investors may continue to be hit with tax bills from capital gains for a while longer as holdings turn over.
Where to search for today’s tax-loss harvesting opportunities
While stocks’ rough first half of 2022 doesn’t necessarily mean the market will end this year on such a sharply negative note, the speed and breadth of the recent market decline created opportunities to potentially harvest losses at midyear across many market segments, particularly in equity sectors that have underperformed year to date. As of June 10, the consumer discretionary, communication services, and information technology sectors were the weakest performers in the S&P 500; in terms of equity style, growth stocks underperformed, as they lagged value stocks by a wide margin.2 In fixed income, bonds with high interest-rate sensitivity—typically, those with long durations—have sustained substantial losses, as they’ve been vulnerable in an environment of rising rates.2 These may be some of the most fertile areas of a portfolio to target when searching for holdings that may present tax-loss harvesting opportunities.
The potential benefits of tax-loss harvesting
While tax-loss harvesting can be complicated, it can be simple in other respects. For example, assume a fund holding that declined in value can be sold to generate a pretax loss of $10,000. That loss may in turn fully offset the net capital gain exposure from the sale of another holding whose value increased by $10,000.
Moreover, losses may be used to help limit tax exposure from noninvestment, ordinary income such as wages, as well as to offset investment gains. Under current law, a capital loss deduction allows an investor to claim up to $3,000 more in losses than in capital gains, meaning investors can reduce their taxable income dollar for dollar, up to that $3,000 limit. (The limit is $1,500 for a taxpayer who's married and files separately.)
However, any investor selling securities as part of a tax-loss harvesting strategy should trade cautiously. An IRS restriction known as the wash sale rule makes it difficult to realize a short-term benefit from quickly getting back into a mutual fund or security after selling the investment at a loss; the loss can't be deducted unless an investor waits at least 30 days to reinvest in that same investment.
What to look for in the months ahead
Around October or November, asset managers typically provide notices to fund shareholders to aid in year-end tax planning. These notices, as well as online disclosures, indicate which funds are expected to pay gains by year end—based on market performance at the date the estimates are made, typically through the end of September—and provide estimates of the amounts of those expected gains as well as funds’ estimated income distributions from dividends, interest, and other net income.
Although this preliminary information is subject to market movements in the closing months of the year, early estimates provide an opportunity to evaluate potential tax liability and, if merited, adjust accounts accordingly through strategies such as tax-loss harvesting. While asset managers typically don’t distribute late-year estimates of funds expected to generate losses, identifying such funds isn’t difficult; year-to-date performance figures are widely available on the websites of asset managers and research firms, as mutual funds are required to publish share prices each business day.
A good time to check in with your financial or tax professional
The recent surge in market volatility may ultimately prove to be a mere bump in the road for investors who stay in the market for the long haul. However, now may be a good time for investors with taxable accounts to check in with a financial professional to review investment goals and discuss tax-loss harvesting opportunities. Professional advice can be especially valuable when it comes to something as potentially complex as tax-loss harvesting, as there’s no guarantee that such a strategy will achieve any particular tax outcome or that it will be in an investor’s best interest over the long run. As always, the John Hancock Investment Management tax center has resources designed to help make your tax planning easier, including a schedule of 2022 tax rates and limits, tax forms, and more. The power of professional advice and solid information can go a long way toward helping to maximize an investor’s tax efficiency.
1 Tax deferral postpones the payment of taxes on asset growth until a later date—meaning 100% of the growth is compounded and won’t be taxed until withdrawn, usually at age 59½ or later, depending on the type of account or contract. Withdrawals from tax deferred accounts are subject to ordinary income tax and, if made before age 59½, may be subject to a 10% penalty tax.
2 S&P Dow Jones Indices, FactSet, as of 6/10/22.
This material does not constitute tax, legal, or accounting advice and neither John Hancock nor any of its agents, employees, or registered representatives are in the business of offering such advice. Please consult your personal tax professional for information about your individual situation. The views and opinions on this site are subject to change and do not constitute investment advice or a recommendation regarding any specific product or security. John Hancock Investment Management and its representatives and affiliates may receive compensation derived from the sale of and/or from any investment made in its products and services.
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