Tax Loss Harvester

Quantifying the Value of Tax Loss Harvesting

Tax Loss Harvester

Tax loss harvesting is one service provided by most financial advisory firms and is one of the hardest to quantify in terms of value added. The professional opinion on this topic ranges from the “do it every chance you get” to the “never, ever.” At Index Fund Advisors, we do believe that tax loss harvesting can provide a benefit to clients depending on market conditions, risk tolerance, and asset base, but not as much as one other investment advisor[i] recently claimed.

For those unfamiliar with tax loss harvesting, here is a quick review.

There may be times when specific asset classes incur significant losses. This creates an opportunity for investors to sell these assets and lock in capital losses. The value of these losses are that they can be used to offset future capital gains incurred (as well as $3,000 of ordinary income per year), creating a slight tax-arbitrage situation. Any losses that are not utilized in the year they were realized can be carried forward as many years as necessary until they are completely used up. Because we accept market efficiency, which posits that stock prices are constantly adjusting to information in order to maintain a positive expected return, investors should always buy back into the market with proceeds.

But you cannot invest in just anything.

According to the IRS Publication 550, in order to avoid violating the Wash Sale Rule, the investor must buy back into a substantially different security, such as the S&P 500 for equity funds (unless an investor is harvesting an S&P 500 Index Fund). After the required 30 days have passed, the investor can sell the S&P 500 index fund and buy back their original funds that they sold at a loss.  This process allows for investors to keep their market exposure while locking in capital losses that they can pocket for the future, but there are still risks involved in the tax loss harvesting process. For more information about IFA’s approach to tax loss harvesting, click here.

The crux of the matter has to do with the double-edged nature of tax loss harvesting. An investor is able to lock in capital losses that can be used to offset future capital gains as well as partially offset ordinary income, but it also lowers the cost basis of the position that originally had a loss, which accelerates the potential to realize gains in the future (in the case of rebalance or raising money for a cash withdrawal, etc.). In other words, does this flurry of activity actually create any substantial value at the end of the day, or are we just spinning our wheels?

We at Index Fund Advisors believe in the power of data; not just stock market data, but also data about our own clients’ investment experience. In terms of tax loss harvesting, we collected a sample of 68 unique tax loss harvesting opportunities between 2007 and March 2014 to evaluate that value added to those clients’ portfolios. Our estimation is based off of a present value of an annuity of tax savings over different time spans and across different tax rates. For example:

Suppose Joe Sample harvested -$40,000 in long term capital losses. Assuming that Mr. Sample pays an effective long term capital gains rate of 20% (combined state and federal) and assuming that these tax losses will help to offset future taxable gains for the next 10 years, the estimated tax savings is $800 per year [(-$40,000 x 0.20)/10 years]. But this does not take into account the time value of money, so we will need to discount these payments by the investor’s opportunity cost of capital, which to IFA is the expected return on their index portfolio. Let’s assume that Mr. Sample is invested in a New IFA Index Portfolio 60. Using 50 years of historical return data, the expected return of a New IFA Index Portfolio 60 is 10.48%, which is Mr. Sample’s opportunity cost of capital. If we discount the $800 per year tax savings by Mr. Sample’s opportunity cost of capital back to today, the estimated value of the tax loss harvesting is $4,816. If Mr. Sample has a portfolio that is currently worth $1,000,000, then the estimated benefit as a percentage of the portfolio is 0.48% in the year that the tax loss harvest was done.

We examined the 68 different tax loss harvesting opportunities we had at IFA assuming a benefit period of 3 – 10 years and assuming an effective capital gains rate between 15% and 25%. It is very important to note that vast majority of our sample comes from 2008, which of course was extreme market conditions, so our results will only indicate the benefit of tax loss harvesting during an extreme market downturn (for the most part). Nevertheless, the results are quite substantial.

On average, tax loss harvesting generated a net benefit to our clients of 1.18% for the years it was performed between 2007 and March 2014. This is a very important distinction since this is much different than assuming 1.0% per year. The calculated benefit is only in the year the tax loss harvesting was performed. This number was higher during 2008 market conditions given the higher amount of losses realized (approximately 1.63% per year). In terms of a percentage of fees, we were able to pay for approximately 3.5 years worth of our management fees, on average, by creating this value for our clients. The two charts below show the different outcomes based on estimated long term capital gains tax rates and estimated benefit of the harvested losses both in terms of a pecentage of AUM and annual advisory fees covered.


We also separated results based on tax loss harvesting equities from tax loss harvesting fixed income. Since most of the tax loss harvesting for equities occurred in 2008 and most of the tax loss harvesting from fixed income occurred in 2014, these results are very sample specific. Harvesting losses in equities created a benefit of 1.63% for our clients, or 5 years worth of advisory management fees while harvesting losses in fixed income created a benefit of 0.04% for our clients or a little over 2 months worth of advisory fees, on average. During normal market conditions, the benefit of tax loss harvesting would be substantially lower.

It is important to keep in mind a few different assumptions. These estimates are more realistic for high net worth individuals who have a very low probability of spending all of their money. For example, if the clients are eventually going to liquidate their entire taxable account, then accelerating the realization of capital losses will lead to a lower estimated benefit (given the very low time period of deferring taxes). If, in contrast, clients have a very low probability of needing to liquidate their taxable account, then the tax deferral period can extend for a long time. So these benefits would not apply to our average client, but more for our high net worth clients ($2M and above). Further, if a client’s risk tolerance is lower, the higher the probability of realizing gains given the need to maintain a proper risk level for that client. Lastly, market conditions that are more volatile will lead to inflated estimates of the benefit of tax loss harvesting. Just looking at the last two major market contractions (2002 and 2008) gives a biased prediction since these events are only expected to occur about every 40 years. When these types of events present themselves, investors should take advantage of them. There will also be clients who will never be expected to benefit from tax loss harvesting (those who invested at the bottom of the credit crisis). It is just too implausible that this client will realize significant losses.

While we maintain that tax loss harvesting can provide a benefit to investors, we acknowledge that this benefit is not as great as that generated from maintaining a proper risk level and rebalancing when necessary. Nonetheless, tax loss harvesting is a service that IFA is committed to providing for our clients given that it creates an opportunity to capitalize on big market swings. As IFA continues to its journey in providing high quality investment management services to our clients, we will continue to update our data as to provide a clear picture of the value of working with us.

Special thanks to Jay D. Franklin, CFA, FSA and Erik Halvorsen, Jr for assisting in the analysis

[i] Wealthfront Inc.