Tax-loss harvesting strategies offer an efficient way to reduce your tax bill - here are three ways to keep the tax benefits coming for longer.
In this article, we explore the dynamics leading to a gradual decrease of loss harvesting opportunities over the longer-term and ways that investors can mitigate that. If you'd like a more foundational overview of key concepts of loss harvesting, please visit this article – where we discuss how tax loss harvesting can turn market volatility into potential tax savings.
Key takeaways
- For investors who want to minimize their tax liabilities on anticipated realized gains in their portfolios, tax-loss harvesting strategies provide opportunities to generate losses that may create tax alpha and reduce their tax bills at the end of the year.
- The historically upwards direction of the markets and the gradual decrease of the portfolio’s cost basis over time, given loss harvesting, can ultimately mute opportunities for tax-loss harvesting over the longer term, resulting in tax alpha decay.
- Even for an investor who doesn’t take proactive action to mitigate tax alpha decay, the market’s natural volatility can help preserve a loss harvesting strategy’s ability to generate tax alpha in the longer-term with our research showing that investors may get the welcome benefit of potential tax savings during periods of unwelcome market volatility.
- Beyond that, investors can take things into their own hands to prolong the potential benefits of tax-loss harvesting — for example, by adding cash to their accounts, gifting appreciated securities to a donor-advised fund, and regularly rebalancing their portfolios to create fresh tax lots.
Investors that want to reduce their U.S. tax liabilities can do so in multiple ways — such as ensuring that the type of account (i.e., taxable or tax-deferred) is best aligned to the holding type, looking for opportunities to tax-loss harvest, tax-aware borrowing, and considering charitable gifting depending on their intents for their wealth. These approaches ultimately result in “tax alpha” for the investor ( i.e., the incremental value-add resulting from tax-efficient management).
For investors looking to minimize their tax bills on anticipated realized gains in their portfolios, tax-loss harvesting strategies provide opportunities to actively generate losses that may be used to reduce their tax bills at the end of the year. Effectively, these strategies allow investors to keep more of their returns by using market volatility to their advantage. Thanks to innovation in technology and intelligent automation, tax-loss harvesting has gone from a year-end manual process to a best practice made possible all year-round — pinpointing losses across the portfolio and harvesting them, all while keeping the risk attributes of the portfolio intact.
With the increasing adoption of tax-loss harvesting strategies among investors, it’s important to address longer-term expectations. While tax-loss harvesting seeks to enhance a portfolio’s after-tax returns by seeking out potential tax savings, there are a few aspects to be cognizant of that will help investors continue generating tax benefits over the longer term, and that will help achieve the strategic intents for their portfolio.
“Tax alpha decay” is the creeping degradation of after-tax returns over the longer term.
If left unchecked, the tax alpha potential of any tax-loss harvesting strategy is likely to erode over time due to two forces:
(1) Markets historically go up. Hold on to any stock long enough, and historical market data shows its value is likely to increase over time. This dynamic means that a client’s potential for tax-loss harvesting is typically highest when first funded, and embedded losses tend to diminish over the long haul.
To illustrate this point, let’s look at the chart below — showing how the percentage stocks at a loss reduces over longer-term return periods (using S&P 500 holdings at the end of 1999 as the starting point).1 Looking forward during that timeframe, a higher percentage of stocks that you started with will tend to be at gains, making the process of finding losses to harvest all the more challenging.
Percentage of stocks at a loss reduces over longer-term return periods (using S&P holdings at the end of 1999 as the starting point)1
Area chart illustrating the % of S&P 500 stocks with negative returns (y-axis) through 2021, using S&P 500 holdings at the end of 1999 as the starting point. S&P 500 holdings were taken at the end of 1999, and performance of those holdings was calculated over the listed time frames, showing total percentage of stocks at a loss for the time frames listed. The chart articulates the point that the percentage of stocks at a loss reduces over longer-term return periods. The percentage of stocks with negative returns spiked up to around ~50% during major historical events such as 9/11 and the Great Financial Crisis of 2007-2008, but steadily declined otherwise.
(2) As losses are harvested in the portfolio, its cost basis will decrease over time. If the stocks purchased as substitutes for the ones that were harvested do well, it increases the spread between the price at which they’re bought (their cost basis) and the stock’s current value.
The combination of the historically upward direction of the market and the gradual decrease of the portfolio’s cost basis over time can ultimately mute the opportunities for tax-loss harvesting over the longer-term, resulting in tax alpha decay.
Even if you don’t take action, the market’s natural volatility can help extend benefits of tax-loss harvesting and delay tax alpha decay.
Market volatility is the primary source of losses to harvest and turn into tax benefits, and can help preserve a loss harvesting strategy’s ability to generate tax alpha — even if an investor chooses to just wait for the next bout of volatility rather than take proactive action to delay tax alpha decay.
Our analysis shows that while the potential for tax alpha may decrease over time, it does not necessarily go to zero — given the ongoing divergence in individual stock returns that occurs even in upward-trending markets. In the figure below, we show the average tax alpha relative to the S&P 500 Index by years since funding, for hypothetical portfolios incepted in each year beginning in 2010 and held through 2021. The portfolios sought to deliver returns similar to the S&P 500 Index, while harvesting losses on a monthly basis in order to enhance after-tax returns.2 While tax alpha did decrease meaningfully after the first few years, the potential for tax alpha remained even in later years — with 80 basis-point average tax alpha in years 5–12.
Bar chart of the average tax alpha relative to the S&P 500 Index by years since funding from 2010 through 2021. Analysis was done using hypothetical portfolios incepted in each year beginning in 2010 and held through 2021. The portfolios sought to deliver returns similar to the S&P 500 Index, while harvesting losses on a monthly basis in order to enhance after-tax returns. Each portfolio was rebalanced on a monthly basis if tax loss harvesting opportunities existed, or if expected tracking error exceeded 1%. While tax alpha decreased meaningfully after the first few years since funding, the potential for tax alpha remained even in later years – with 80bps average tax alpha in years 5-12. The returns shown are annualized and compounded over time. Note that all returns are hypothetical in nature and should not be relied on to reflect actual client experiences or performance.
Bar chart illustrating the relationship between market volatility (represented by VIX) and potential tax savings. VIX is the ticker symbol for the Chicago Board Options Exchange's CBOE Volatility Index, which is a real-time market index representing the market's expectations for volatility over the coming 30 days. Analysis period is between 2007-2021. To construct the analysis, we simulated a cash-funded portfolio that was created on the first day of each year and subsequently rebalanced on a monthly basis if tax loss harvesting opportunities were present or tracking error exceeded 1%. The chart shows that months with the highest VIX level also experienced the highest tax alpha, ranging up to 3%. From these results, we can see that investors may experience potential tax savings during periods of market volatility. Note that all returns are hypothetical in nature and should not be relied on to reflect actual client experiences or performance.
While it might be an unattractive environment for most investors, prolonged periods of volatility can effectively extend the potential benefits that we tend to see early on with tax-loss harvesting accounts and help delay tax alpha decay.
Rather than wait for the next bout of volatility, here are three steps investors can proactively take to mitigate tax alpha decay and optimize tax efficiency of their portfolios.
Investors can take matters into their own hands by contributing cash into their accounts to introduce fresh tax lots.5 New dollars invested create a new (many times higher) cost basis, so any ensuing volatility after a cash contribution may create additional opportunities for harvesting those fresh tax lots. To illustrate that, we compared tax alpha over 12 years for two portfolios —both incepted in 2010. Portfolio A (represented by the navy bar) stayed invested without any subsequent cash contributions post-inception. Portfolio B (represented by the teal bar) also stayed invested — but made cash contributions of 5% of its market value at the beginning of each year starting in 2010.6
Portfolio B’s annual cash contributions injected a fresh set of tax lots each year into the account, increasing the opportunity for tax-loss harvesting to take advantage of any subsequent market volatility. Portfolio B’s cumulative tax alpha experience became increasingly better over time relative to Portfolio A — with 4.5% of additional cumulative tax alpha at the end of 2021 given the annual cash contributions into the account.
Bar chart representing the tax alpha experience of two portfolios, Portfolio A (blue bar) and Portfolio B (purple bar). Analysis period is between 2010-2021 (x-axis) compared to cumulative tax alpha relative to the S&P 500 (y-axis). Portfolio A illustrates no cash contributions to the portfolio over the 12 years represented, while Portfolio B contributed 5% of its value in cash annually. Each portfolio is rebalanced on a monthly basis if tax loss harvesting opportunities exist, or if expected tracking error exceeds 1%. Portfolio B saw 4.5% of additional cumulative tax alpha at the end of 2021 given additional loss harvesting opportunities created by fresh tax lots from annual cash contributions. The returns shown are annualized and compounded over time. Note that all returns are hypothetical in nature and should not be relied on to reflect actual client experiences or performance.
Investors who have philanthropy as one of the objectives for their wealth can benefit from potential tax deductions by gifting appreciated securities (e.g., to a donor-advised fund). For investors who itemize deductions on their tax returns instead of taking the standard deduction, gifting qualified appreciated stock that has been held for over a year (e.g., to a donor-advised fund) can unlock an additional way to save more on taxes.
Donating stock that’s been held for over a year to charity generally allows the investor to take a tax deduction for the full fair market value — subject to limitations based on adjusted gross income — that can be used in the tax year in which the gift is made with any excess charitable deductions carried forward for use in five subsequent years. Furthermore, the capital gains tax that would be incurred from selling the stock and donating the proceeds can potentially be eliminated — increasing the value of the charitable contribution by over 20%.7
Once appreciated stock is donated, the portfolio can be replenished with cash to purchase the same or similar stock.8 This will create fresh tax lots with higher cost bases — complementing the tax benefit of charitable gifting by leading the way for additional tax-loss harvesting opportunities and extending the runway for tax benefits.9
This chart details tax savings outcomes from two different scenarios: Scenario 1 where the client sells their shares and donates the after-tax proceeds to a Donor Advised Fund (DAF), and Scenario 2 where the client donates their qualified appreciated stock directly to the DAF. Both scenarios assume that the client has adjusted gross income (AGI) of $1mm per year. The client who donated the qualified appreciated stock directly to the DAF saves ~$33,510 more on taxes and was able to donate an additional $23,800 to the DAF. Analysis assumes the top tax rate at the federal level (40.8%) as well as a 3.8 % Medicare surtax.
By regularly monitoring and rebalancing their portfolios, investors can create more fresh tax lots — leading to new potential opportunities for ongoing harvesting. A robust approach to rebalancing is key to keeping the portfolio in line with its investment objectives. In addition to that, new tax lots created with the proceeds of trimming outsized exposures can provide additional runway for tax-loss harvesting, extending the benefits of a loss-harvesting strategy.
Want to learn more?
For investors who are looking to reduce their tax bills on anticipated realized gains, ongoing tax-loss harvesting is a powerful tool that can potentially help them keep more dollars invested and enhance after-tax returns. In addition to a thoughtful planning and execution of a tax-loss harvesting strategy, there are additional steps that investors can take to get the most from their tax-smart investments. Reach out to your J.P. Morgan team to learn more.
1Analysis period: 1999–2021. S&P 500 holdings taken at the end of 1999, and performance of those holdings was calculated over the listed time frames, showing total percentage of stocks at a loss for the time frames listed. GFC = Great Financial Crisis of 2007–2008.
2Analysis period: 2010–2021. All returns are hypothetical in nature and should not be relied on to reflect actual client experiences or performance. Each portfolio is rebalanced on a monthly basis if tax-loss harvesting opportunities exist, or if expected tracking error exceeds 1%. The returns shown are annualized and compounded over time.
3Analysis period: 2007–2021. All returns are hypothetical in nature and should not be relied on to reflect actual client experiences or performance. A simulated cash funded portfolio was created on the first day of each year, and subsequently rebalanced on a monthly basis if tax-loss harvesting opportunities were present, or if expected tracking error exceeded 1%. Each portfolio created is managed in accordance with these rules through the end of 2021.
4VIX is the ticker symbol for the Chicago Board Options Exchange's CBOE Volatility Index, which is a real-time market index representing the market's expectations for volatility over the coming 30 days. Indices are not investment products and may not be considered for investment.
5A tax lot contains details of a security’s acquisition, such as acquisition date, cost basis, and size of transaction. Introducing cash into the portfolio allows for purchasing securities at their current cost, increasing the possibility that any ensuing volatility will result in loss-harvesting opportunities.
6Analysis period: 2010–2021. All returns are hypothetical in nature and should not be relied on to reflect actual client experiences or performance. Each portfolio is rebalanced on a monthly basis if tax-loss harvesting opportunities exist, or if expected tracking error exceeds 1%. The returns shown are annualized and compounded over time.
7Assumes maximum federal long-term capital gains tax rate of 20%, plus the Medicare surtax of 3.8%. In this example, comparison is made between an investor selling their holding and paying tax on the proceeds, and then donating the net proceeds versus an investor who donates their qualified appreciated stock.
8When purchasing securities to replenish the account, investors should be mindful of the wash sale rule in the case where losses were harvested on the same or substantially identical security in this account, or other accounts of the same taxpayer.
9This hypothetical example is for illustrative purposes only. Rates shown assume top tax rate at federal level, including 3.8% Medicare surtax, and doesn’t take into account any state or local taxes. The tax savings shown is the tax deduction multiplied by the donor’s income tax rate (40.8% in this example), minus the long-term capital gains taxes paid. This example assumes that the taxpayer has adjusted gross income (AGI) of $1 million per year. Cash contributions to donor-advised funds are deductible up to 60% of the taxpayer's AGI.
The fair market value of appreciated stock contributions to donor-advised funds are deductible up to 30% of the taxpayer's AGI.
Contributions in excess of the percentage limitation may be carried forward for use by the taxpayer in the next five tax years.
