Taxes: They can’t be avoided. But they can be managed. For example, a tax-loss harvesting strategy may help you keep more of what you earn by helping minimize what you owe in taxes on investments, leaving you with more money to invest to help maximize your return on life. This article explains how tax-loss harvesting works and why we think a customizable separately managed account (SMA) can be an effective way to potentially maximize tax efficiency.1
What is tax-loss harvesting?
Simply put, tax-loss harvesting is a strategy designed to reduce your overall tax bill so you can keep more of what you earn from your investments. It works by selling investments at a loss and using those losses to offset some, or possibly all, of the capital gains from investments that you sold at a profit.
For example, if an investor buys a stock at $400 and sells it for $500, they realize a capital gain of $100. This will trigger a capital gains tax (the amount will depend on variables such as the investor’s marginal tax rate, state and local tax rates and how long they held the stock). However, if the investor sells another security at a $100 loss, they can use that realized loss to offset the gain from the sale of the other stock. As a result, the net realized gain is reduced and the investor’s overall tax bill is lowered.
How you might apply tax-loss harvesting in an equity strategy can vary depending on your objective and risk tolerance. If your objective is increased after-tax returns and you are comfortable with an index-oriented strategy, you may consider a customizable SMA, which allows a manager to reduce your tax bill by “harvesting” losses while maintaining broad market exposure.
Here’s how tax-loss harvesting works:
There are many ways for investors to end up with a tax bill at year-end. Examples include investment gains from other active managers, capital gains distributions from mutual funds, selling appreciated real estate, private equity distributions or investing in hedge funds which may not be tax efficient.
Note the purpose of tax-loss harvesting is not to pick losing stocks. It is simply to help investors benefit from naturally occurring market volatility and dispersion in stock returns. Think about it this way: Even in years when an index such as the S&P 500 delivers a positive return, not every single stock in the index has a positive return throughout the year. Some stocks experience losses throughout the year and may even end the year in the red.
While market returns vary from year to year, market volatility is a constant. Volatility and dispersion of stocks’ returns create potential opportunities to harvest losses, which adds value to an investment portfolio by potentially increasing after-tax returns. Of course, the amount of potential tax savings depends on the market environment— typically, a year with low market returns will provide more harvesting opportunities than a high return year. But we believe tax-loss harvesting can work in any market environment because losses exist in all market environments.
Losses exist in all markets
Tax-loss harvesting seeks to provide value in all market environments.
Tax efficiency: How tax-managed SMAs differ from ETFs and index funds
Exchange-traded Funds (ETFs) generally have low expenses, and most are passively managed and structured to track an index. But when it comes to tax efficiency, there are three key differences between them and SMAs:
1. An ETF or index fund investor owns shares in a fund that tracks an index. With an ETF, an investor may only harvest a loss when the entire index is down. In contrast, the SMA investor directly owns the individual securities in their portfolio. This is sometimes referred to as “direct indexing”. By owning all of the underlying securities, a manager can harvest losses when the index is down but can also opportunistically sell individual stocks trading at a loss in pursuit of higher tax savings and after-tax returns compared to an ETF.
2. In an ETF or an index fund, all realized losses within the fund can only be used to offset realized gains within the fund, whereas realized losses in a SMA can be used to offset gains anywhere else in an investor’s portfolio. This can potentially add up to greater tax savings. (For more on ETFs see disclosures.)
3. SMAs can generally be funded with both cash and in-kind stock contributions. Existing stock positions in an investor’s portfolio can be transitioned in-kind into an SMA and managed with greater tax efficiency.
Long-term potential benefits of tax-loss harvesting for an investment portfolio
When repeated in a systematic way, year in and year out, tax-loss harvesting can reduce your tax bill. That means an investor is not only saving money on their taxes in a given year, but they can reinvest those tax savings for potential growth in the future. And the longer a portfolio stays invested, the more time it has to grow and compound.
Who may potentially benefit from tax-loss harvesting
All taxable investors may potentially benefit from tax-loss harvesting strategies; investors in the highest tax brackets stand to potentially benefit the most because the higher the tax bracket, the bigger the potential savings.
It also helps to have capital gains from other parts of an investor’s portfolio. This could include gains from selling down concentrated stock, private equity or other active managers. If an investor doesn’t have capital gains from other investments in a particular year, harvested losses can be used to offset $3,000 in ordinary income per year. 3 This includes interest, wages, dividends and net income from a business. Any excess losses can be carried forward indefinitely and used to offset capital gains in the future.
Investors who may want to consider tax-loss harvesting include those who plan to donate their portfolio to charity or bequest it to heirs, as this would not involve realizing capital gains. Investors who plan to liquidate their portfolio eventually would then pay taxes on realized gains. But if they employed tax-loss harvesting over a long investment horizon, they may find that the portfolio appreciated more than it would have had it been invested in an index strategy without tax management.
Access Goldman Sachs’ proprietary tax-loss harvesting strategy
To learn how to incorporate tax-loss harvesting into your investing strategy, connect with a PFM personal financial advisor. As a PFM client, you have access to the best thinking of Goldman Sachs Consumer & Wealth Management’s Investment Strategies Group, access to tax-efficient personalized portfolios as well as the firm’s other vast resources. Working as a partner in your corner, your advisor can help you create and adapt your financial strategy to help minimize financial stress and maximize your return on life, today and tomorrow.
1 Goldman Sachs PFM does not provide tax advice. Clients should obtain their own independent tax advice based on their particular circumstances. GS PFM makes recommendations based on the specific needs and circumstances of each client. All services are subject to suitability and availability.
2 Diversification does not protect an investor from market risk and does not ensure a profit.
3 See Capital Losses: https://www.irs.gov/pub/irs-pd...
Separately Managed Account (SMA): A portfolio of individual securities managed on an investor’s behalf by a professional asset management firm. Because the investor owns the underlying securities, and SMA provides more control than other investment vehicles and can be customized to fit individual investor needs.
ETF: A type of security that tracks an index, sector, commodity or other asset but can be purchased or sold on an exchange, like an individual stock.
Capital Gains: An increase in an asset's value, which for tax purposes is considered to be realized when the asset is sold. A capital gain may be short-term (one year or less) or long-term (more than one year) and must be claimed on income taxes.
S&P 500: The S&P 500 Index is the Standard & Poor's 500 Composite Stock Prices Index of 500 stocks, an unmanaged index of common stock prices. The index figures do not reflect any deduction for fees, expenses or taxes. An investor cannot invest directly in an unmanaged index.
Dispersion refers to the range of possible returns on a type of investment.
In-Kind Stock Contributions refer to transactions in which an investor moves assets from one brokerage account to another as-is. There's no selling off assets or buying new ones.
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All investments contain risk and may lose value. Exchange-Traded Funds are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed, or sold, may be worth more or less than their original cost. ETFs may yield investment results that, before expenses, generally correspond to the price and yield of a particular index. There is no assurance that the price and yield performance of the index can be fully matched.
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Based on “Tax-Loss Harvesting Strategies: How They Work” by “Goldman Sachs Asset Management (“GSAM”)”, © 2021 Goldman Sachs.
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