14 Tax-Loss Harvesting: Improving after-tax returns
This chapter covers
- The basics of tax-loss harvesting - what it is, and the potential benefits
- The “wash sale” rule and its implications on 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 will 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 which 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.
14.1 The economics of tax-loss harvesting
Tax-loss harvesting 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
Both benefits are important, and the differences can be somewhat subtle. Let’s go into some more detail on each.