14 Tax-loss harvesting: Improving after-tax returns
This chapter covers
- Understanding tax-loss harvesting and its potential benefits
- The “wash-sale” rule and its implications for tax-loss harvesting
- Implementing a tax-loss harvesting system for ETFs
Investors hold assets that are expected to increase in value over time. However, the increases are never straight lines—there are always downturns along the way. As a result, investors sometimes hold assets at a loss. Tax-loss harvesting (TLH) is the process of selectively selling assets currently trading at a loss. Selling depreciated assets creates realized losses that can then be used to offset realized gains or ordinary income. The proceeds from the sales of depreciated assets can be reinvested in similar (but not identical!) assets to maintain the investor’s desired exposures.
TLH is a fairly common feature among robo-advisors—half of the robo-advisors surveyed in chapter 1 include TLH as a feature. This chapter explains the mechanics and benefits of TLH and shows what an implementation using ETFs might look like. The exact tax rules used in this chapter are specific to US-based investors, but the concepts apply to all taxable investors.
14.1 The economics of tax-loss harvesting
TLH benefits investors in two ways:
- Delaying tax payments from the present to the future, known as tax deferral
- Achieving a lower tax rate on realized gains or income