Tax Loss Harvesting: Beware of Unrealistic Expectations

One common method used to “un-lock” concentrated potions is a tax loss harvesting portfolio. Tax loss harvesting is a way to reduce the tax impact of selling a portion of the concentrated holding, and facilitates the creation of a more diversified portfolio.  

Assumptions

There are a few key assumptions that inform our thinking about tax loss harvesting, and have meaningful implications for the success of the strategy.

• Portfolio tax status:Harvesting strategies only work in taxable portfolios!
• Offsetting capital gains: A critical assumption is that the client will have realized gains to offset; realized capital losses can only offset a small amount of ordinary income each year.
• Capital losses only delay the tax bill: Harvesting strategies may delay taxes, but eventually most clients will pay taxes on their appreciated securities, unless they gift the securities to charity or leave them to beneficiaries who receive a step-up in basis at death.
• Tax planning is critical: Clients who expect to be in higher tax brackets in the future may want to accelerate rather than delay gain realization!
• Loss harvesting results typically decline over time: Unless cash is regularly added to a portfolio, a strategy of selling “losers” while holding on to “winners” often leads to a portfolio filled with stocks held at gains, limiting the opportunity to take losses. The best results in a tax loss harvesting strategy are often found in the first five years.

Beware of Inflated Claims

We’ve noted with a mix of amusement and consternation lofty claims about the effectiveness of tax loss harvesting from some online advisors (also known as robo-advisors). Although we are proponents for harvesting strategies, some of the claims we’ve seen are unrealistic given our more than a decade of experience managing tax loss harvesting portfolios and results we’ve seen from competitors we respect.  

The claims made by online advisors arguably represent the triumph of favorably simulated back-tested results over actual experience. Although we believe that back-testing simulations serve an important role in portfolio management, we are skeptical of investment managers who use back-tested results too prominently in their marketing campaigns. 

Conclusion

Investor and media attention typically is devoted to high-profile managers that have eye-catching returns. This is an understandable fact of life in a headline-driven world, but in our view performance tends to be hard to predict and few managers deliver market-beating performance over extended periods of time.  Taxes are often a “silent killer,”eroding investor returns while getting insufficient attention other than in the days leading up to year end or April 15. 

The good news for investors is that they can take steps to manage their tax bill, with a tax loss harvesting strategy being an easy-to-implement, low cost and transparent way to do so.  

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