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Turning market volatility into tax savings

Key takeaways

  • Tax-loss harvesting can provide some extra value to a portfolio. It tends to be especially valuable through times of market volatility, by generating capital losses that can offset future taxes on potential gains and income.
  • While it's possible for investors to harvest tax losses themselves, it may be challenging and complex to accomplish without disrupting your investment strategy.
  • In a managed account, a professional manager can handle tax-loss harvesting for you, so you accumulate capital losses while still keeping your investment strategy on track.
  • Tax-loss harvesting has generated an estimated $4.9 billion in potential tax savings since 2017 for Fidelity® Wealth Services, Fidelity® Strategic Disciplines, and Fidelity Managed FidFoliosSM clients.1

No one roots for their investments to decline. In a perfect world, investors would see gains each time they opened a statement or clicked into their accounts. But in the real world, the economy and markets often run into hurdles. While stocks have historically generated positive returns over the long term, the market can be highly volatile and historical performance is not a guarantee of future success.

With the right management approach, it is possible to turn those temporary setbacks into powerful tax assets, which investors can use to reduce or even potentially eliminate capital-gains taxes on their investments (and potentially even reduce taxes on ordinary income) for years to come.

Tax-loss harvesting is the practice of selling investments that are down in order to realize a capital loss, which may be used to offset taxes in the current tax year or carried forward to use in future years. Using it most effectively can take a fair amount of vigilance and active management to avoid wash sales and to maintain a desired asset allocation. But when it's done correctly, tax-loss harvesting can be particularly powerful in times of market volatility—letting investors convert temporary market downturns into long-term tax benefits.

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A lighter lift with a managed account

While some do-it-yourself investors harvest investment losses themselves, doing so can be complex and challenging.

For example, if an investor sells Company A's stock at a loss on November 1, they'd have to wait until December 2, at the earliest, to buy it back if they wanted to recognize a tax loss (under the wash-sale rule, investors can't claim a capital loss on their taxes if they buy the same, or a "substantially identical," investment in the 30 days before or after the date when they sold a position at a loss). However, if the investor waits until December 2, they run the risk that Company A stages a big rally in the meantime, and they miss it. Between November 1 and December 2 the investor's asset allocation and risk profile would also be thrown off. If the investor is harvesting losses from multiple positions at once, the complexity only grows.

However, consider whether a professionally managed account could help. If you invest with a managed account solution that uses tax-loss harvesting, such as taxable accounts with Fidelity® Wealth Services, Fidelity® Strategic Disciplines, and Fidelity® Managed FidFoliosSM, your portfolio manager has the ability to harvest losses on an ongoing basis when appropriate—while also striving to maintain the desired diversification and/or asset allocation, thanks to the support of portfolio analytics.2 (Learn more about Fidelity's managed account solutions.)

"The value of a professionally managed account is we're evaluating that account every single day," says Kip Saunders, vice president of Managed Accounts Investment Solutions with Fidelity. "When the market is down, we consider grabbing those losses while keeping the portfolio aligned to the desired diversification and/or asset allocation, so when the market comes back the investor has an appropriate portfolio plus all the benefits of tax losses harvested during the downturn."

How professional managers harvest losses

Key to effective tax-loss harvesting is keeping the portfolio's asset allocation and risk profile on track while harvesting losses. In a Fidelity managed account that employs tax-smart strategies,2 portfolio managers accomplish this by swapping in an investment (or a group of investments) that has similar risk and return characteristics to the one that's sold at a loss, but that isn't "substantially identical" for tax purposes.3

For example, if an account is invested in individual stocks, managers could sell one stock at a loss and buy another in the same industry with similar risk characteristics (such as similar market capitalization and volatility). The new investment is chosen in an effort to keep the portfolio's overall allocation and risk exposures on track during the 30-day wash-sale period.

Once the 30-day window has passed, managers can potentially swap back into the original investment, or leave the new investment in the portfolio. If the market keeps declining, managers can continue to swap investments periodically, to potentially capture additional tax assets. (Note that repurchasing the original investment at a lower price will also lower the investor's cost basis in the position. Because of this, the investor may face a higher tax bill if or when they sell the position than they otherwise would have.)

An asset with no expiration date

Of course, recognizing losses may not feel like much of a benefit if an investor doesn't currently hold any positions at a gain. But in fact, capital losses can be carried forward into future tax years, to offset gains if and when the market makes a comeback. Generally, taxpayers can also use losses they carry forward to offset gains realized outside of their investment portfolio, like on the sale of a home, if they have capital gains in excess of the exclusion (which generally lets sellers exclude up to $250,000 in gains from their income or $500,000 for certain married taxpayers filing a joint return and certain surviving spouses).

If the capital losses realized or carried forward exceed a taxpayer's gains for a given year, they will offset ordinary income, which is generally taxed at higher rates than long-term capital gains.4 More specifically, if a taxpayer still has losses remaining after offsetting all capital gains for a given year, up to $3,000 of their remaining losses will offset ordinary income for that year (for individual and married-filing-jointly taxpayers; spouses who file separately instead each offset up to $1,500 of ordinary income).5

Here's how the numbers could hypothetically work out for an investor who generates a capital loss of $10,000 in one year and then carries it forward. This example assumes that the investor realizes capital gains of $2,000 in the first year after the loss, then $1,000 in each of the following 2 years. Because the investor's capital loss is greater than her gains for the first 2 years, she also offsets ordinary income in those years.

Figures are hypothetical and for illustrative purposes only. Source: Fidelity.

"Tax losses never expire," says Saunders (with the caveat that it is possible for tax laws to change). "It's an asset you can potentially hold on to for your entire life."

How big of a potential benefit can it offer?

Just as tax-loss harvesting itself is complex, so is quantifying its benefits. (Note: Certain managed account clients can see the estimated tax savings that have been generated for them anytime online.)

One way of understanding the potential benefit of tax-loss harvesting generally is by looking at the historical after-tax performance of a composite, which shows the average performance of thousands of accounts invested in similar portfolios. The composite shown below uses tax rates provided by investors to compare the historical after-tax performance (net of fees and including the benefits of tax-loss harvesting) of investors in certain managed accounts with their accounts' pre-tax total return.6

As the chart below shows, while tax management can add value in many market environments, its benefits are often felt most strongly in the years that follow market corrections and downturns, when investors are able to accumulate losses.

Chart shows value added from tax-loss harvesting in terms of rolling 12-month returns, for the Fidelity® Tax-Managed US Equity Index Strategy composite. The composite returns represent the asset-weighted performance of the Strategic Advisers Tax-Managed US Large Cap SMA (TMFWS) sleeve in a client’s Fidelity® Wealth Services/Portfolio Advisory Services account and the asset-weighted performance of accounts in the Fidelity Tax-Managed US Equity Index Strategy (TMSD) of Fidelity® Strategic Disciplines. For additional details see footnote 6. Source: Fidelity.

If percentage-point value added seems like an abstract measure to follow, consider this: Since 2017, tax-loss harvesting has generated an estimated $4.9 billion in potential tax savings for Fidelity® Wealth Services, Fidelity® Strategic Disciplines, and Fidelity Managed FidFoliosSM clients.1

For details, consult with your tax advisor

Taxes are complex, and the exact benefit that tax-loss harvesting provides in any one investor's situation depends on a range of factors (including state and local tax rates, whether the alternative minimum tax applies, where that investor falls within income tax brackets,7 and more).

Because of that complexity, the examples above and the potential benefits reported to individual clients are estimates. These estimates are calculated using actual harvested losses, and with tax rates provided by clients. But the true value of tax-loss harvesting for a given person could be higher or lower than these estimates. Over time, tax-loss harvesting generally lowers an investor's cost basis in their portfolio (because an individual investment repurchased at a lower price will have a lowered cost basis). This means that tax-loss harvesting can result in a higher tax bill if or when an investor ultimately sells a position or liquidates their portfolio.

Finally, while tax-loss harvesting can be fruitful, it can also make tax time more complicated. Consult with your tax professional if you'd like to learn more about the impact of these factors and about the value of tax-loss harvesting in general.

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1. Source: Fidelity. Estimated tax savings calculated from January 1, 2017, through August 26, 2022, using actual harvested losses and with tax rates provided by clients. Includes figures from closed accounts. For investors to realize tax savings, they must have realized capital gains to offset or they are able to offset ordinary income up to $3,000. 2. Tax-smart (i.e., tax-sensitive) investing techniques, including tax-loss harvesting, are applied in managing certain taxable accounts on a limited basis, at the discretion of the portfolio manager, primarily with respect to determining when assets in a client's account should be bought or sold. Assets contributed may be sold for a taxable gain or loss at any time. There are no guarantees as to the effectiveness of the tax-smart investing techniques applied in serving to reduce or minimize a client's overall tax liabilities, or as to the tax results that may be generated by a given transaction. 3. "Publication 550 (2021), Investment Income and Expenses," Internal Revenue Service, accessed on June 1, 2022, 4. Note that dividends and interest income are not capital gains, but could be offset as part of income. 5. "Topic No. 409 Capital Gains and Losses," Internal Revenue Service, accessed on June 1, 2022, 6. The composite returns represent the asset-weighted performance of the Strategic Advisers Tax-Managed U.S. Large Cap SMA (TMFWS) sleeve in a client's Fidelity® Wealth Services – Portfolio Advisory Services account and the asset-weighted performance of accounts in the Fidelity Tax-Managed U.S. Equity Index Strategy (TMSD) of Fidelity® Strategic Disciplines. The TMFWS accounts included in the composite are generally subject to higher fees than TMSD accounts. Returns for TMSD were included in the composite beginning on 8/1/2015 on both a pre-tax and after-tax basis. The performance data featured herein represents past performance, which is no guarantee of future results. Investment return and principal value of an investment will fluctuate; therefore, you may have a gain or loss when your shares are sold. Current performance may be higher or lower than the performance data quoted. A client's underlying holdings may differ from those of other accounts in the composite. Total returns are based on the portfolio manager's composite, are historical, net of fees, and include changes in share value and reinvestment of dividends, interest income, and capital gains, if any. Fees are fully described in the applicable Program Fundamentals and Client Agreement. Life returns are reported since the inception date of the composite. Returns less than or equal to one year are cumulative. Composite performance is asset-weighted while pretax benchmark returns are not asset weighted. You cannot invest directly in an index. Securities indexes are not subject to fees and expenses typically associated with managed accounts or investment funds. Please see the endnotes for additional information about how returns are calculated. ^Prior to July 1, 2019, the strategy used the S&P 500® Index as its reference index in managing accounts, and the returns shown under "Pretax Benchmark Return (Fidelity U.S. Large Cap IndexSM)" include return information for the S&P 500® Index for periods prior to that date linked to the return information for the Fidelity U.S. Large Cap IndexSM for periods from that date forward. 7. Tax-loss harvesting can be used to offset income and generate value even for investors in the 0% bracket for long-term capital gains and qualified dividends. However, to the extent that such investors also generate cap gains, some or all of the benefit may be lost. Therefore, in the case of investors in the 0% bracket for long-term capital gains and qualified dividends, tax-loss harvesting strategies may be most effective for those who realize little or no capital gains in their taxable accounts.

Calculation of composite returns. Composite returns represent the asset- weighted composite performance of accounts managed to the indicated strategy. Accounts must have at least one full calendar month of returns to be included in the composite. Accounts subject to significant investment restrictions provided by clients are excluded from the composite. In limited circumstances, additional accounts with nonstandard characteristics are excluded from the composite. Accounts with a do-not-trade restriction are removed from the composite once the restriction has been on the account for 30 days. Accounts for which clients provided short-term and long-term tax rates of zero are also excluded from the composite. Account performance is calculated using time-weighted methodology, which minimizes the effect of cash flows in and out of accounts and related impacts to account returns during the period. Composite returns are calculated using asset-weighted methodology, which takes into account the differing sizes of client accounts (e.g., considers larger and smaller accounts proportionately). Individual accounts will vary based on individual tax and investment situations and, therefore, performance may be better or worse than the performance shown. Performance shown is net of the actual investment management fees paid by each client, including any fee credits applicable to the account, as well as any underlying fund expenses, and reflects the changes in share prices and the reinvestment of any interest, dividends, or capital gains distributions if applicable. These are manually reinvested, but not necessarily into the issuing fund or security. Mutual fund redemption fees that would otherwise apply may be paid the program sponsor. Larger accounts may, by percentage, pay lower management fees than smaller accounts.

Calculation of the after-tax composite returns. The following assumptions have been used as part of the after-tax composite returns calculations. All distributions of qualified dividend income are assumed to meet the required holding period. In most cases, specific ID cost-basis methodology rather than average cost basis is applied when managing client accounts. Performance and rates of return are calculated net of the payment of the quarterly advisory fee on client accounts where applicable. Returns are calculated net of the payment of underlying mutual fund expenses as described in individual fund prospectuses. Individual share price and returns will vary, and you may have a gain or loss when your shares are sold. Performance, whether reported on a pre- or after-tax basis, includes accrued interest for the following securities: fixed-rate bonds, fixed-rate government bonds, and commercial paper. Other securities are computed on a cash basis only, so, for example, accrued interest on money market funds, mutual funds, and accrued dividends on equities are not included in the calculation. For accounts with individual bonds, amortization and accretion for bonds are not included in performance calculations. After-tax composite returns are calculated based on a daily valuation time-weighted methodology estimating the impact of federal ordinary income taxes, Medicare surtaxes, and the alternative minimum tax where customers have indicated this applies. For accounts migrated from PPS, the account was calculated in some historical months using the modified Dietz method or, depending on the relative size of cashflows, a daily valuation method, taking into consideration the impact of federal income taxes based on the activity in client accounts. Returns are calculated by adjusting for actual transactions (sales, dividend earnings, etc.) that have taken place in the accounts, and by assuming that (i) each category of income is taxed at individual marginal rates in effect for the period in which the taxable transaction took place and is computed based on long-term capital gains rate and marginal income tax rate information provided by the client, and (ii) cost-basis and holding period information provided by the client is accurate. Cost-basis information provided in customer communications may not reflect all adjustments to such information that may be necessary due to events outside the control of, or unknown to, Fidelity (e.g., wash sales resulting from purchases and sales of securities in non-FWS accounts). Such after-tax returns take into account the effect of federal income taxes only; taxes other than federal income taxes including state and local taxes, foreign taxes on non-U.S. investments, and estate, gift, and generation-skipping transfer taxes, are not taken into account. The calculation assumes that a client reclaims in full any excess foreign tax withheld and that the client is able to take a U.S. foreign tax credit in an amount equal to any foreign taxes paid. Clients should be aware that the reclamation process for foreign tax withholding can be complex and time- consuming. Clients may engage an agent (for a fee) to assist them in the reclamation process. These assumptions will increase an account’s after- tax performance; the amount of the increase will depend on the total mix of foreign securities held and their applicable foreign tax rates, as well as the volume of distributions from those securities. After-tax composite returns do not take into account the tax consequences associated with income accrual, deductions with respect to debt obligations held in client accounts, or federal income tax limitations on capital losses. Any year-end adjustments for dividends with respect to classifications as qualified versus non-qualified are not taken into account. Withdrawals from client accounts during the performance period result in adjustments to take into account unrealized capital gains across all securities in such account, as well as the actual capital gains realized on the securities. Any realized short-term or long-term capital gain or loss retains its character in the after-tax calculation. The gain/loss for any account is applied in the month incurred, and there is no carryforward. The calculation assumes that net losses (e.g., losses minus gains within the account) are used to offset gains realized outside the account in the same month, and the imputed tax benefit of such a net loss is added to that month’s return. This can inflate the value of the losses to the extent that there are no items outside the account against which they can be applied. The calculation assumes that taxes are paid from outside the account. Taxes are recognized in the month in which they are incurred. This may inflate the value of some short-term losses if they are offset by long-term gains in subsequent months. Our after-tax performance calculation methodology uses the full value of harvested tax losses without regard to any future taxes that would be owed on a subsequent sale of any new investment purchased in an account following the harvesting of a tax loss. That assumption may not be appropriate in all client situations but is appropriate in situations such as when (1) the new investment is donated (and not sold) by the client as part of a charitable gift, (2) the client passes away and leaves the investment to heirs, (3) the client long-term capital gains rate is 0% when they start withdrawing assets and realizing gains, (4) harvested losses exceed the amount of gains for the life the account, or (5) where the proceeds from the sale of the original investment are not reinvested. To harvest a tax loss, the portfolio manager sells an investment for less than its purchase price, which creates the loss for tax purposes, at which time such loss can be used as described above. In most cases, the proceeds from the sale of that original investment are then reinvested. If the new investment appreciates in value and is sold, the investor will realize a capital gain to the extent of the appreciation. This gain may occur in the same year as the investment or many years later, depending on market circumstances and investment positioning. In some cases, depending on the amount of the gain, the amount of taxes owed could be greater than the value of the realized capital loss. However, by harvesting the loss and reinvesting the proceeds in a new investment, investors are able to keep their money invested. It is important to understand that the value of tax-loss harvesting for any particular client can only be determined by fully examining a client’s investment and tax decisions for the life the account and the client, which our methodology does not attempt to do. Clients and potential clients should speak with their tax advisors for more information about how our tax-loss harvesting approach could provide value under their specific circumstances. After-tax composite returns may exceed pre-tax returns as a result of an imputed tax benefit received upon realization of tax losses. Changes in laws and regulations may have a material impact on pre- and/or after-tax investment results. Strategic Advisers relies on information provided by clients in an effort to provide tax-sensitive investment management, and does not offer tax advice. Strategic Advisers can make no guarantees as to the effectiveness of the tax- sensitive investment management techniques applied in seeking to reduce or minimize a client’s overall tax liabilities or as to the tax results that may be generated by a given transaction. Consult your tax advisor for additional details. After-tax composite benchmark returns represent an asset-weighted composite of clients’ individual after-tax benchmark returns. Each client’s personal after-tax benchmark is composed of mutual funds (index funds where available) in the same asset class percentages as the client’s investment strategy. The after-tax benchmark uses mutual funds as investable alternatives to market indexes in order to provide a benchmark that takes into account the associated tax consequences of these investable alternatives. The after-tax benchmark returns implicitly take into account the net expense ratio of their component mutual funds because mutual funds report performance net of their expense. They assume reinvestment of dividends and capital gains, if applicable. The after-tax benchmark also takes into consideration the tax impact of rebalancing the benchmark portfolio, assuming the same tax rates as are applicable to each client’s account, as well as an adjustment for the level of unrealized gains in each account. The after-tax composite benchmark return is calculated assuming the use of the “average cost-basis method” for calculating the tax basis of mutual fund shares. All indexes are unmanaged and include reinvestment of interest and/or dividends. Please note that an investor cannot invest directly in an index. The performance data featured represents past performance, which is no guarantee of future results. Investment return and principal value of an investment will fluctuate. Current performance may be higher or lower than the performance data quoted.

Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

Past performance is no guarantee of future results.

Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

Fidelity® Wealth Services, Fidelity Managed FidFolios℠ and Fidelity® Strategic Disciplines are advisory services offered by Fidelity Personal and Workplace Advisors LLC (FPWA), a registered investment adviser, for a fee. Brokerage services provided by Fidelity Brokerage Services LLC (FBS), and custodial and related services provided by National Financial Services LLC (NFS), each a member NYSE and SIPC. FPWA, FBS and NFS are Fidelity Investments companies.

Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917