Taxes affect investment returns. The good news is that guidance to invest in a tax-smart way is accessible to all types of investors. So as another tax season looms, it’s a good time for investors to assess their portfolios through a tax lens.
One tax that can take investors by surprise is the capital-gains tax on the sale of an appreciated security. The way to help mitigate capital gains is called tax-loss harvesting.
Tax-loss harvesting is the practice of offsetting capital gains with capital losses. You sell an investment that has declined in value and use that loss to reduce your taxable capital gains. The proceeds from selling can be reinvested in a different security in the same asset class so that you aren’t changing the overall profile of your portfolio. It’s something investors can do throughout the year for the biggest impact.
Choose your tax-loss harvesting strategy
How you take advantage of tax-loss harvesting depends on how you prefer to invest, your appetite for doing some heavy lifting with your portfolio and your unique financial picture. Here are three approaches for different types of investors:
1. Do-it-yourself (DIY) investors: If you handle all of your own investment decisions and activities — and are able to go deeper in your investing process — then DIY tax-loss harvesting may be for you. This will require monitoring your portfolio and making decisions to sell investments that have declined — whether they be individual stocks, funds or bonds — and then reinvesting the proceeds in a different security that will maintain your asset allocation strategy. When tax time comes, you will report the loss you harvested to reduce your taxable capital gains to potentially offset ordinary income.
If you go the DIY route, think ahead about how frequently you want to tax-loss harvest. Many people and even financial advisers tax-loss harvest once a year. But harvesting losses more regularly and proactively — say when there is a big market set-back or you are rebalancing your portfolio — could potentially save you more money over the long run.
Consider doing some research to make sure you are up to speed on the more nuanced mechanics of tax-loss harvesting and the common pitfalls. For example, investors should be aware that if they sell a security at a loss and buy the same of a “substantially identical” security within 30 days before or after the sale, the loss is typically disallowed by the IRS. This is called the “wash-sale” rule.
2. Digital investors: If DIY tax-loss harvesting is not for you, and you are more of a tech-oriented investor, you could consider using an automated investing offering (also known as a robo-adviser) that includes tax-loss harvesting. These low-cost platforms use technology backed by investment professionals to create and monitor portfolios. Some hybrid offerings also offer access to a human adviser for when you want to talk with a professional.
Robo-advisers that offer tax-loss harvesting identify losers in the portfolio as well as appropriate replacement investments, and handle the selling and buying automatically. Some platforms engage in more frequent and proactive tax-loss harvesting activity than others, so it’s worth looking under the hood for a better understanding of the level of harvesting activity you will get. Determine, for instance, whether the robo-adviser harvests losses at set periods throughout the year and/or responds proactively to market volatility to maximize opportunities.
3. Advised investors: For investors with significant assets and potential capital gain exposure, or who prefer working with a professional, an adviser who offers tax-loss harvesting may be the best option.
If you go this route, it’s important to understand how your adviser approaches tax-loss harvesting before committing. Some handle tax-loss harvesting themselves (i.e., manually). Typically they do it on an annual- or quarterly basis. You may consider asking them for more frequent or more opportunistic harvesting.
Other advisers utilize a strategy called “direct indexing” to pursue tax-loss harvesting opportunities. It essentially allows investors to directly own a large representative sample of stocks in a specific index. Owning the stocks rather than owning an index mutual-fund or index ETF allows for more granular management of winning and losing stocks with the goal of achieving “tax alpha” — outperformance of the index on an after-tax basis.
Direct indexing — also called personalized indexing — isn’t a new strategy, but it is in the early innings of broad-scale adoption and a lot of innovation is happening in the space, including the ability to customize your portfolio to align with your values. New technologies and lower costs are making it possible to offer direct indexing to a larger universe of investors.
D.J. Tierney is a senior portfolio strategist at Schwab Asset Management.
Neither the tax-loss harvesting strategy nor any discussion herein is intended as tax advice, and Schwab Asset Management does not represent that any particular tax consequences will be obtained. Tax-loss harvesting involves certain risks including unintended tax implications. Investors should consult with their tax advisers and refer to Internal Revenue Service at www.irs.gov about the consequences. Diversification and asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market.