Typically, harvests happen seasonally. Strawberries ripen in the spring, corn is eye high by the Fourth of July, those grapes get stomped in the fall, and chestnuts roast on winter fires.

Tax-loss harvesting is different. Those who are familiar with the strategy tend to mistakenly assume that losses are best harvested at year-end, when taxes are top of mind. In reality, tax-loss harvests can happen whenever market conditions and your best interests warrant it.

What is tax-loss harvesting?

When properly applied, tax-loss harvesting is the equivalent of turning your financial lemons into lemonade by converting market downturns (whenever they may occur) into tangible tax savings. A successful tax-loss harvest lowers your tax bill, without substantially altering or impacting your long-term investment outcomes.

How does it work?

If you sell all or part of a position in your taxable account when it is worth less than you paid for it, this generates a realized capital loss. You can use that loss to offset capital gains and other income in the year you realize it, or you can carry it forward into future years. (There are quite a few caveats on how to report losses, gains and other income. A tax professional should be consulted, but that’s the general premise.)

Here’s a three-step summary of the round trip typically involved:

1. Sell all or part of a position in your portfolio when it is worth less than you paid for it.
2. Reinvest the proceeds in a similar (not “substantially identical”) position.
3. Return the proceeds to the original position no sooner than 31 days later (after the IRS’s “wash sale rule” period has passed).

Again, once the dust has settled, our goal is to have generated a substantive capital loss to report on your tax returns, without dramatically altering your market positions during or after the event.

Any catches?

Remember, tax-loss harvests should occur when market conditions allow for them AND when your best interests warrant it. There are several reasons that not every available loss should be harvested. To name a few:

Costs – The potential tax savings may not offset the trading costs involved. Before the harvest, do the math.

Tax planning – A tax-loss harvest can reduce your taxes in the short-term, but may generate higher capital gains taxes later on (by lowering the basis of your holdings). Loss harvests should be managed in concert with your larger tax planning projections.

Asset location – Holdings in your tax-sheltered accounts (such as your IRA) don’t generate taxable gains or realized losses when sold, so they aren’t available to harvest.

It’s never fun to endure market downturns, but they are an inherent part of nearly every investor’s journey toward accumulating new wealth. When they occur, we can sometimes soften the sting by leveraging losses to your advantage. That’s why we keep a year-round eye on our clients’ holdings, so we can be ready to spring into action any time a harvesting opportunity may be ripe for the picking.

Let us know if we can ever answer any questions about this or other tax-planning strategies you may have in mind.

If it’s April, taxes are on the minds of most Americans. Based on decisions made throughout the prior calendar year, investors might be caught with a nasty tax surprise and need to write a large check to Uncle Sam. We consider your taxes daily to avoid these surprises at Hill Investment Group. Practices we implement, like tax loss harvesting and asset location (tax-inefficient asset classes in tax-deferred accounts), can meaningfully reduce the taxes an investor may owe annually. However, we are talking about one of the most impactful practices today: investing in ETFs rather than mutual funds.

ETFs and mutual funds are two types of investment vehicles and are simply different ways of holding a group of underlying securities like stocks or bonds. Most investment strategies can use either structure to execute their investment strategy. For example, Dimensional Fund Advisors and Avantis Investors, two companies we invest with, have both a mutual fund and an ETF for their US Small Value strategies. For each firm, the strategies are run the same way. However, they have a different legal structure that, in turn, has different tax consequences. 

ETFs rarely distribute capital gains at the end of the year because of the way they rebalance and trade.

On the other hand, mutual funds almost always distribute some capital gains. The table below outlines the capital gain distributions for four specific funds in 2022.

Both the mutual funds distributed ~5% of their value in capital gains, whereas the ETFs did not distribute any. This means that investors in the mutual fund owed about 1% (assuming a 20% capital gains tax rate) in taxes to the government. For every $100,000 invested in the small value strategy, they owed $1,000 in taxes this April. Investors in the ETF, the same strategy but with a different legal structure, owed $0 in taxes this April.

By investing primarily in ETFs across our models, we avoid capital gain distributions for our clients in those funds and meaningfully reduce their tax bills yearly.

Let me know if you have questions or comments about this or any other investment-related topics by emailing me at: zenz@hillinvestmentgroup.com.

Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and unless otherwise stated, are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed here. Past performance is not indicative of future results.

“Typically, harvests happen seasonally. Strawberries ripen in the spring, corn is eye-high by the Fourth of July, those grapes get stomped in the fall, and chestnuts roast on winter fires.

Tax-loss harvesting is different. Those familiar with the strategy mistakenly assume that losses are best harvested at year-end when taxes are top of mind. In reality, tax-loss harvests can happen whenever market conditions and your best interests warrant it.”

From a 2016 post we did on tax-loss harvesting.

Unlike many advisors and do-it-yourself investors, we are on the lookout for tax-loss harvesting opportunities throughout the year. Many people (if they harvest at all) only harvest losses once per year, usually at the last minute in late December. Not us, not you if you’re a Hill Investment Group client. Remember the market decline in March 2020? If your advisor waited until December to harvest your losses, they were likely wiped away. 2020 is a perfect example of why, at HIG, we are opportunistic when it comes to harvest time.

The big question folks have debated is how much all this work is worth? How do we quantify the benefit to you? The Wall Street Journal caught our attention with Derek Horstmeyer’s report claiming the value to be more than 1%. The estimates go even higher if your tax rate is at the top end. If their estimates are somewhere in the ballpark, harvesting looks like a sound strategy year-round with the potential to show you some real money.

You can read about the study here.