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.
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.
"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.