Each year presents a unique set of opportunities for tax-efficient investing; tax rates go up or down, rules governing deductions and exemptions change, and investment performance varies across the markets, with some asset classes delivering sizable capital gains and others generating losses. Entering the closing months of 2018, investors may wish to explore several potential avenues to make year-end portfolio adjustments that could enhance the after-tax returns of investments held in taxable accounts.
One option is to identify holdings whose year-to-date performance gives them high potential to produce full-year losses and consider selling some of those securities, thereby generating losses that can help offset taxable exposure from equity holdings expected to generate capital gains. This year, international equity and fixed income are good starting points for identifying holdings that offer potential tax benefits, if sold in a timely fashion to offset gains elsewhere in a portfolio. As for domestic equities, even with the positive performance of broad U.S. indexes, 3 of the 11 sectors within the S&P 500 Index—telecommunication services, consumer staples, and materials—had negative results through August, and nearly half of the stocks in the Dow Jones Industrial Average—14 of 30—were down as well.1 So there may also be opportunities to find loss-generating securities among U.S. equity holdings.
The new tax law brings new opportunities
This year is one of the relatively rare times when investors can take comfort in having little uncertainty about tax policy. It’s quite a contrast with last year, when details of the 2017 Tax Cuts and Jobs Act weren’t resolved until late December, leaving many financial advisors and their clients reluctant to make end-of-year portfolio adjustments, given the lack of clarity about the legislation’s final shape. Among other benefits, the law reduced individual tax rates across income brackets and increased the standard deduction for most individuals. Details on brackets, contribution limits for tax-deferred accounts, required minimum distributions, and more can be found here.
One area where the new tax law didn’t have much of a measurable impact involves long-term capital gains and qualified dividend income. Rates for these types of income were adjusted so that they no longer conform precisely with the new standard tax brackets for overall income, but many of the cutoffs between different tax rates are roughly the same as they were before. Depending on an investor’s income level, the income thresholds that trigger higher tax rates can have a significant impact on after-tax returns of investments generating qualified dividend income or long-term capital gains (defined as investments held for longer than 12 months at the time of sale of that investment; those held for less than 12 months trigger the investor’s rate for ordinary income, which may be higher than the rate on long-term gains).
Another big year for U.S. equities—and for taxable gains
With the new tax law in place, the positive year-to-date investment performance for U.S. equities builds on the nine consecutive years of positive full-year total returns that the S&P 500 Index posted dating to 2009. The index has more than quadrupled in price terms since the market hit bottom in early 2009. That huge gain means there’s a high likelihood that investors will continue to be hit with tax bills from capital gains generated by investments held in taxable accounts. (In tax-deferred accounts, such as IRAs or a 401(k)s, capital gains are not taxable for the year the gain occurred.) Capital gains are triggered as portfolio managers sell holdings that have appreciated in value. Investors share the tax burden in the same calendar year that the net gains were realized.
The potential benefits of tax-loss harvesting
Taxable exposure from investment income can potentially be reduced through tax-loss harvesting. While this approach can be complicated, it’s simple at a fundamental level. For example, assume a fund holding that declined in value can be sold to generate a pretax loss of $10,000. That loss can in turn fully offset the net capital gain exposure from the sale of another holding whose value increased by $10,000.
What’s more, losses can be used to limit tax exposure from noninvestment income, 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.
The potential benefits of tax-loss harvesting can open new opportunities for investors with taxable accounts. For example, parents with children entering college or homeowners starting a renovation project may find themselves in need of additional income to cover rising expenses. If they and their advisors determine a withdrawal from invested savings is merited, it may be possible to substantially reduce the resulting tax bill through a well-designed tax-loss harvesting strategy.
How to get started
Tax-loss harvesting requires identifying which portfolio holdings appear likely to distribute net capital gains before the end of the year while also finding holdings that are likely to sustain losses. Around October or November, asset managers typically provide notices to 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. (Also, if a fund is expected to distribute capital gains, an investor should wait until after the distribution date to invest any new cash, if the fund is held in a taxable account. Failing to wait until after distribution could trigger a tax bill covering gains that the investor didn’t profit from, because the gains occurred before the investment was made.) 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 advisor
Now is an opportune time for investors to review financial plans with advisors and explore how to maximize tax efficiency, given the changes resulting from the new tax law and the recent strong performance of U.S. equities coupled with the relative underperformance of most international stocks and fixed-income allocations. Professional advice can be especially valuable when it comes to something as potentially complex as tax-loss harvesting, as there’s no guarantee that it 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 make your tax planning easier, including a schedule of 2018 tax rates and limits, tax forms, and more. The power of professional advice and solid information can go a long way toward maximizing an investor’s tax efficiency.
1 S&P Dow Jones Indices, September 2018.
Past performance is not indicative of future results.