Tax Loss Harvester

Quantifying the Value of Tax Loss Harvesting: An Update

Tax Loss Harvester

In August of 2014 we released a study that attempted to quantify the value of providing tax loss harvesting services using a data sample from our own clients’ experiences. As we mentioned in the original study, there has been dispute among investment professionals on whether going through the process of tax loss harvesting provides a substantial benefit for investors.

The Analysis

In our original study, we looked at sample data from tax loss harvesting events that took place from 2007 to the middle of 2014. It included 293 harvested positions across 68 different households. Assuming a few different capital gains rates and years in which the capital losses would be used, we were able to quantify the value of tax loss harvesting in terms of a client’s AUM as well as the number of quarterly fees covered.

Given the level of volatility that we experienced in 2015, we were able to expand our data set to include an additional 171 positions harvested across 137 households bringing our overall sample size to 464 positions across 205 households. We simplified our analysis by removing the assumptions about different tax rates and benefit periods and assumed the highest income and long-term capital gains rates. We also assumed that the entire benefit would be realized in the current year, which means that we do not need to adjust the benefit by each investor’s opportunity cost of capital (return of their IFA Index Portfolio).

The Total TLH Benefit

Understanding what makes up the entire TLH benefit is crucial. Our metric is made up of the following:

  • Total tax savings - total losses multiplied by highest income and long-term capital gains rates. This also includes the potential gains or losses from selling the S&P 500 Index fund and buying back the original DFA position after the 31-day “wash sale” period.
  • Transaction Costs - the fees charged by Fidelity, Charles Schwab, or TD Ameritrade to buy and sell mutual funds
  • Opportunity Cost - the gain or loss from being in the S&P 500 Index fund versus the original DFA fund for the 31-day “wash sale” period.

The hardest component to understand is the opportunity cost. An example will help. Let’s say that one of our clients has the opportunity to harvest their DFA Emerging Markets Value (DFEVX) position in their taxable account. We would sell DFEVX to harvest the losses and invest the proceeds in an S&P 500 Index Fund. It is important to maintain proper equity exposure versus just sitting in cash due to the positive return we would expect in any given day. After 31 days, we would sell the S&P 500 position and buy back DFEVX. How DFEVX performs in relation to the S&P 500 alternative also needs to be considered in quantifying the overall benefit of the tax loss harvest. If DFEVX outperformed the S&P 500 by a substantial margin over the 31-day “wash sale” period, then it would have been beneficial for the investor to just stay invested in DFEVX and not go through the process. In essence, if the harvested position outperforms the S&P 500 over “wash sale” period, this is considered a loss to the investor. The opposite is also true. If the S&P 500 outperforms the original harvested position over the “wash sale” period, then this is a gain to the investor.

The Results

The updated results of our analysis are shown in the table below.

TLH Sub-Sample

Positions Harvested

Household
Covered

Losses Harvested

TLH Benefit

Average Benefit (%)

2008-2009

248 49 $14,405,262 $3,601,316 2.78%

2013-2014

45 19 $857,998 $215,487 0.07%

2015

171 137 $12,443,722 $3,276,604 0.33%

Total

464 205 $27,706,983 $7,093,406 0.89%

 

From 2008 to 2015, we have harvested 464 different positions across 205 households. In total we have harvested $27,706,983 in capital losses and have created $7,093,406 in benefit through tax loss harvesting. In terms of AUM, the average client experienced a benefit of 0.89% by going through the tax loss harvesting process. This is just 0.01% shy of our maximum advisory fee.

There are a couple of key pieces of information that stand out.

First, the average benefit (% of AUM) is heavily skewed by the market events from 2008-2009. These types of market events are expected to happen very rarely, so the results should be taken with a grain of salt. When these types of events do happen, it is definitely worthwhile to go through the tax loss harvesting process. As you can see, the average benefit in terms of AUM was almost 3%. We believe the results from 2015 are more indicative of the type of benefit investors should expect during “normal” market fluctuations.

Second, IFA has been able to cover more of our clients during the most recent market turmoil. We tripled the amount of households that went through the TLH process and created a very similar overall TLH Benefit to that of 2008-2009, where losses were more substantial.

Understanding the TLH Conundrum

The obscurity mainly comes from the double-edged nature of the process itself. While we are capturing capital losses that can be used to offset future capital gains (as well as a small amount of ordinary income), it also lowers the overall cost basis of the portfolio, thus accelerating the possible future realization of capital gains when investors need to raise money for a withdrawal or simply from rebalancing their portfolio back to their targeted asset allocation. There are transaction costs involved in the process as well. It would take an entire investor’s lifetime to quantify the actual benefit of going through this process, but we can make some general assumptions.

First, all else equal, the more likely an investor is not going to spend down a substantial part of their taxable accounts, the more likely tax loss harvesting is going to provide a positive benefit. Second, all else equal, the more tax sensitive an investor is, the more likely tax loss harvesting is going to provide a positive benefit. Third, all else equal, the less risk averse an investor is, the more likely tax loss harvesting will provide a positive benefit. In summary, for high net worth individuals, who will pass along most of their taxable assets to beneficiaries and have a somewhat higher capacity to take risk, the more likely tax loss harvesting is a valuable service. You can find more information about IFA’s Tax Loss Harvesting Policy here.

Conclusion

The value of tax loss harvesting is difficult to quantify. We do not know for sure whether or not it is going to workout over an investor’s lifetime until the very end, but we can make some general assumptions regarding its benefit by looking at the probability of spending down taxable assets, overall sensitivity to taxes, and risk tolerance. Based on our own data, tax loss harvesting can provide a benefit to a certain group of investors. Although other industry practitioners may cite an ongoing benefit of 1% per year, we believe that the overall benefit is more modest, but still positive. As we continue to gather and collect data on our own client’s results, we will continue to provide updates to the value that IFA provides in terms of our services.