How do tax-smart strategies actually work?
Using a tax-smart strategy can help investors keep more of what they earn. Now may be an opportune time to consider adding one to your portfolio.
There are two big reasons why: taxes may be poised to move higher and expectations for future market performance are lower than what we’ve experienced in recent years.
An active tax management approach continually seeks opportunities to enhance your after-tax returns. But just how does it work? To illustrate, let’s look at the investment journeys of two hypothetical families to help show the difference that tax loss harvesting can have on a portfolio. Remember, this scenario is intended to simply illustrate how a tax loss harvesting strategy seeks to enhance a portfolio’s after-tax returns and is not a guarantee of results.1
Tax-Smart Portfolio vs. an Index
The Washingtons
The Washingtons are the matriarch and patriarch of a large New York family. They own a successful family business that has been operating for generations. As part of their goals-based plan, they aim to grow and preserve a portion of their wealth to pass on to future generations.
The Cabellos
The Cabellos live in San Jose, California. They’re entrepreneurs who have recently experienced a liquidity event from a company they invested in. Given their high federal and state tax rates, they want to preserve more income to help meet their long-term goals.
Both families have similar investment goals: track the performance of the S&P 500 via direct index investing with each family beginning to invest in 2007 with the same initial investment. The difference is that the Cabellos are using a tax-smart strategy. They sold their losing stocks, used those losses to offset taxable gains in other parts of their portfolio and reinvested the proceeds into similar stocks to keep their investment strategy on track.2
1 All investments involve risk, including loss of principal. There can be no assurance that any return objectives will be met. Any examples used are generic, hypothetical, and for illustration purposes only. The results shown in these materials are based on illustrative/hypothetical examples and do not represent actual investment decisions or results. No representation is made that any investor will, or is likely to, achieve results comparable to the illustrative/hypothetical examples shown. Past performance does not guarantee future results.
2 IMPORTANT: The impact of a tax loss harvesting strategy depends upon a variety of conditions, including the actual gains and losses incurred on holdings and future tax rates.
For illustrative purposes only. Informational analysis assuming 1% tax alpha for the portfolio vs. the S&P 500’s after-tax returns, and are not meant to be representative of actual results achieved by the manager while investing in the respective strategies over the time periods shown. Calculations use the max applicable federal rate: taxes on income from dividends are using the max federal rate of 20% plus the 3.8% NII Tax, for a combined rate of 23.8%. For ST gains the highest federal marginal income tax rate of 37% plus the 3.8% NII Tax is used, for a combined rate of 40.8%. For long-term gains, the highest U.S. federal marginal income tax rate of 20% plus the 3.8% NII Tax is applied, for a combined rate of 23.8%. No state or local taxes are assumed. No representation is being made that any portfolio will or is likely to achieve profits or losses similar to those shown. Past performance is not indicative of future results. Returns will fluctuate and an investment upon redemption may be worth more or less than its original value. Examples used are generic, hypothetical, and for illustration purposes only. Case studies are based on illustrative examples and do not represent actual investment decisions or results. The impact of a tax loss harvesting strategy depends upon a variety of conditions, including the actual gains and losses incurred on holdings and future tax rates.
The need for personalized tax management is more important than ever
Return Expectations are Falling
Investors have realized strong returns for the last 10 years, but should expect significantly less looking forward
Bar chart of the annualized return of U.S. large cap equities, represented by the S&P 500 Total Return Index and U.S. investment grade bonds, represented by the Bloomberg U.S. Aggregate Bond Index. Returns for the last 10 years are shown alongside expected returns for the next 10-15 years. Annual equity return for the last 10 years was 16.5% and annual fixed income return was 2.9%. Expected annual equity return for the next 10-15 years is 4.1% and expected annual return for fixed income is 2.6%. A footnote explains that expected performance is estimated using passive asset class assumptions and is not intended as a recommendation or promise of future performance.
Tax Costs May Be Rising
Taxes are near multi-decade lows, and may be poised for a shift higher
Line graph displaying U.S. short term and long term capital gains taxes. It begins in 1954 with short term capital gains taxes at 91% and long term capital gains taxes at 25%. Over time, the short term rate fell 54% to its current level of 37%. It has risen since its bottom in 1982 at 20%. The long term rate has remained range-bound between 15% (2003-2012) and 35% (1972-1977). It currently sits at 23.8%, just 1.2% off its 1954 level. A footnote indicates that maximum individual federal income tax rates are used.
Source: J.P. Morgan Asset Management’s 2022 Long Term Capital Market Assumptions as of 12/31/21. Equity returns represent the S&P 500 Total Return Index and Fixed Income returns represent the Bloomberg US Aggregate Bond Index. You cannot invest directly in an index. For equity and fixed income assumptions we assume current index regional weight in composite indices with multiple countries/regions. All returns are nominal. For the full opportunity set, please contact your J.P. Morgan team. All estimates on this page are in U.S. dollar terms. Given the complex risk-reward trade-offs involved, we advise clients to rely on judgment as well as quantitative optimization approaches in setting strategic allocations to all of these asset classes. Please note that all information shown is based on qualitative analysis. Exclusive reliance on this information is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. Note that these asset class assumptions are passive only–they do not consider the impact of active management. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell securities. Forecasts of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. Realized and expected returns are annualized. Maximum individual federal income tax rates used for the Tax Costs chart. Tax costs source: U.S. Department of the Treasury, Internal Revenue Service, J.P. Morgan Asset Management data as of 12/31/21. JPMorgan Chase & Co., its affiliates and employees do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors before engaging in any financial transactions.
