Tax-loss harvesting can be used as an opportunistic value-add within a well-diversified portfolio.
The effects of taxes on an investor's portfolio over the long term are substantial and fairly predictable. Given today's low-return environment, the productive value of each dollar invested must be considered. Within the context of a well-diversified portfolio, even the savviest of investors will suffer losses in core holdings from time to time. And as we near the end of fiscal year 2011, investors should consider how to make the most efficient use of those losses through tax-loss harvesting.
Investors can always add value by booking or harvesting losses but may find that some moments are more opportune than others. These can include instances of portfolio rebalancing or perhaps moving from an active to a passive strategy providing similar exposure. In general, tax-loss harvesting can be used to capitalize on opportunities that your existing exposures have provided in the short run. However, tax-avoidance strategies should not dominate your overall investing approach. We recommend that investors build out sound long-term portfolio allocations and use tax-loss harvesting strategies to add incremental value.
Let's consider scenario one. You've been holding fund XYZ for some time, and to your dismay, the market hasn't gone your way. In the first scenario, you decide to hold on for the ride, and the market comes back so that you're even on the position. You haven't lost any money, and you don't have a taxable gain to report.
In scenario two, you sell XYZ at the bottom and roll into a fund that maintains nearly identical market exposure while tracking a different index or operating under a different structure--call it ABC. Upon sale of XYZ, you book a taxable loss. Effectively, this lowers your tax burden for the current period. In addition to the cash you rolled from XYZ to ABC, you could also invest (out of pocket) the amount by which your tax burden has been decreased: the amount that the government will eventually reimburse you for on your tax return.
As with the first scenario, the market makes a similar percentage swing back into your favor. The difference in scenario two is that you have a greater amount invested because of the taxable loss that you "harvested." Because you harvested the loss and reinvested it, the same percentage recovery delivers a higher total return.
Note the number of benefits that come in addition to a higher total return. The investor wasn't forced to alter his overall allocations because he rolled into an alternative providing very similar market exposure. This may not be possible in niche offerings, but finding a suitable alternative for a core fund shouldn't prove challenging. On top of the higher total return, the fact that taxes on those returns will be realized further into the future means that they are more likely to be taxed at 15% long-term capital gains rates.
Consider a real-world example. Perhaps you held a position in iPath MSCI India Index ETN INP and intend to use it as a long-term core holding. You bought the note on July 8, 2011, after a quick 5% drop. Unfortunately, after holding the position for about three months, you find yourself down 26% on Oct. 3, 2011. You look to harvest your loss. On Oct. 4, 2011, you roll into iShares S&P India Nifty 50 INDY, which has maintained a correlation to INP of 0.99 over the past year and should serve as a good alternative. By selling INP, you book the loss while maintaining your India allocation through INDY's Nifty 50 exposure. After the 30-day restriction period, you could shift back to INP. Assuming you switch back to INDY at the time of this writing (Oct. 28), the loss that you harvested would more than cover the tax on the 15.5% capital gain you realized. Without reinvestment of the harvested loss, you would currently have 85.5% of your initial position. If you had reinvested the harvested loss, as described earlier, you would have recouped nearly 96% of the original position.
The Wash Sale
Though the Internal Revenue Service has remained slightly ambiguous on the definitions, investors are not allowed to deduct losses from sales of securities in a "wash sale." According to the IRS, a wash sale occurs when you sell securities at a loss, and within 30 days before or after the sale, you do the following: