Tax Loss Harvesting

by | Dec 28, 2020 | Investing, Smart Financial Tips

2020 has presented us with many challenges, but also some opportunities.  A disciplined adherence to a good plan can pay long-term dividends at times like this that “try men’s souls.”[i]

In case you missed it, earlier this year when Covid-19 hit, we experienced a precipitous decline in equities, rapidly followed by a sharp rebound and ultimately a complete recovery and new record highs in equity indices–all in less than a full year!

So what were the opportunities?

First of all, rebalancing.  When your plan calls for a target weighting for equity, a sharp decline may trigger a purchase of more equity, back up to the target weighting.  This often occurs at a time of great fear and requires discipline and intestinal fortitude.[ii]  When markets recover, you do better than you would have if you had not acted.  Likewise, when markets rise sharply, a sale of equity may be triggered so as to keep risk (i.e., equity exposure) where it was intended to be.  This year there has been a lot of that activity.

What else?

Tax loss harvesting.  Despite popular practice, you can’t wait until year end and “take a look” for tax loss harvesting opportunities in fast-moving markets like these.  This year you would have missed your chances almost entirely.  But if you had a team watching for these opportunities throughout the year, you probably had substantial losses realized earlier in the year during the downturn.

Let me tell you a little more about how it works.  If you own equity mutual funds, for example, these will move up and down with equity markets.  When they appreciate, the gain remains unrealized and therefore untaxed as long as you don’t sell them.  When they fall, if you sell them and realize the losses, those can be used to offset realized gains elsewhere, now or in the future.  You are allowed to “carry them forward.”

A disciplined strategy can accumulate realized losses over time, and these will save you taxes later when you sell equities, a business, a house, or any other appreciated asset.  It can be substantial.

One more thing.  As this activity takes place to create tax benefits for you, it is also important to reinvest the sales proceeds to keep your portfolio on target.  This year, you could well have been selling equity funds with losses and buying similar funds, and actually adding to your total equity (rebalancing) as you did it.  A portfolio doing this would have realized losses for tax purposes, rebalanced back to the full equity weighting, and experienced the full benefit of the recovery.

If this sounds like a lot of work, it is.  It happens behind the scenes, and you might not notice, or you might notice and wonder why losses are being realized!  We have had that question many times.  We hope this explanation helps in that regard.  And if all this trading sounds expensive, keep in mind that we seek to minimize transactions (and thus transaction costs) throughout the process–harvesting losses only when we think the benefit will be meaningful and rebalancing the total equity/fixed income allocation with as few trades possible.

This has been a difficult year in many ways, but it is always important to keep our focus on the plan and execute with discipline, especially in times like these.

[i] The words are those of Thomas Paine during that first terrible winter of the Revolutionary War.  He lived for a time in what is now the “Thomas Paine Cottage Museum” across the street from my High School in New Rochelle NY.

[ii] Old Marine Corps phrase.

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