We find out how to reduce taxes in a taxable trading account by applying tax loss-harvesting and learn that loss harvesting is most effective in accounts which hold index funds.
Tax loss-harvesting definition
Tax loss-harvesting is a trading process which seeks to reduce the taxes for a taxable investment account. In the loss-harvesting process, realized losses on investments are used to first offset taxable gains and then to reduce taxable ordinary income by up to $3,000 per year. And, if executed correctly, loss-harvesting does not interfere with the account’s underlying investment policy.
Illustration
Let's say we construct a portfolio at the beginning of the year by purchasing shares in, say, ten funds. At the end of the year, positions in some of the funds have gained in value and positions in the other funds have declined in value. Overall, though, the portfolio has realized capital gains and produced ordinary income. Therefore, the portfolio has taxable capital gains and taxable income.
At the end of the year, we sell the positions which have declined in value and thus realize losses. Taxation of capital gains is based on the net amount of gains realized by the investor over the course of the year. Thus, losses realized on the sale of positions may be deducted from gains. After all gains have been offset, up to $3,000 of any remaining realized losses may be deducted from ordinary income.[1]
Let’s assume that in this illustration realized losses exactly offset realized gains and ordinary income. Hence, there are no taxable gains and no taxable income. Does that mean our portfolio necessarily produced a zero return for the year? No--the realized losses offset realized gains and ordinary income. However, the portfolio may have any amount of unrealized gains (which are not taxable).
Thus far, we have sold positions whose values have declined since the beginning of the year and used the realized losses to offset realized gains and possibly ordinary income too depending on the extent of the realized losses. In doing so, we have minimized taxable gains and income.
In order to maintain the structure of our portfolio, and thus our overall investment goal, we must replace the funds sold. But we cannot immediately replace them with the same funds—if we repurchase shares within 30 days of selling them for non-portfolio management reasons, the realized losses would be disallowed by the IRS. Instead, we must replace the funds with securities that are, according to the IRS, not substantially similar. So we are looking for replacement funds which have the same underlying characteristics as the funds sold, but which are not substantially similar.
Index funds are particularly well suited to tax-loss harvesting
This may sound like a contradiction, but in a portfolio holding index funds, a suitable replacement is an index fund which tracks a similar, but not the same, index. For example, there are several emerging markets indices and a number of index funds which track each emerging markets index. Let’s say we sell the shares of the fund which tracks emerging markets index A. We would then immediately purchase shares of the fund which tracks emerging markets index B. Our replacement fund is not considered substantially similar to the fund whose shares we sold. However, the correlation of the returns between the replacement fund and the fund whose shares we have sold is sufficiently high such that the fundamental characteristics of our portfolio have not measurably changed.
Conclusion
A strategy of offsetting realized gains and ordinary income by realizing losses by selling fund positions which have declined in value since initial purchase reduces the taxes for a taxable investment portfolio. If the portfolio contains index funds, the funds sold may be immediately replaced with alternative index funds such that the underlying structure of the portfolio remains unchanged.
Freshfield's portfolios are constructed from index funds and thus are particularly well-suited to the loss-harvesting process. Freshfield employs loss-harvesting to reduce taxes on clients' taxable portfolios.
Dr. Andy Lawson is the principal of Freshfield Investments, a Registered Investment Advisory firm in Plano, Texas serving clients locally and nationwide. Freshfield provides investment management and financial planning as a fee-only, fiduciary. To book a virtual or in-person complimentary consultation, please visit our Contact page.
[1] If any realized losses remain after offsetting gains and deducting $3,000 against ordinary income, they may be carried forward indefinitely for use in future tax years.