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Tax loss harvesting can help enhance investors' after-tax returns
In today’s market environment, the need for active tax management is greater than ever. With elevated volatility and more modest forward-looking return expectations – clients are increasingly seeking personalized tax-managed strategies that can possibly deliver after-tax returns. While tax loss harvesting strategies are evergreen, now is an especially opportune time for U.S. investors to think about incorporating tax loss harvesting into their portfolios’ ongoing management, for the following two reasons:
- Volatility is high. China’s lockdowns, surging inflation and the U.S. Federal Reserve’s response to inflation on top of unstable geopolitics and supply chain issues are all creating a bumpy ride for the markets. This makes now a particularly opportune time for clients to incorporate active tax management into their portfolios. Ongoing tax loss harvesting can help transform market volatility into tax benefits for you, by seeking to realize losses that you could use to offset your capital gains and potentially reduce taxes you owe. Instead of just riding out the bumps in markets, you can use the market’s natural volatility to your advantage, by crystallizing losses along the way.
- Forward-looking returns are lower. After a decade of very strong market returns, we expect more modest performance for both equity and fixed income investments looking ahead. Through the end of 2021, the S&P 500 Index returned 16.5% annualized on a 10-year basis, while our forward-looking forecast estimates for U.S. Large Cap Equities are closer to a 4.1% return over the next 10-15 years.1 It’s more important than ever for clients to squeeze the most they can out of their returns. Tax loss harvesting can help you take home more of your return, while staying close to your objectives.
Of the two, today’s high volatility argues most forcefully for ensuring that you have active tax management in place. If the market is going to rollercoaster, you’ll want to benefit not only when it climbs, but also when it drops.
Extracting tax benefits from today’s market volatility
While volatility is always a natural part of investing, it is currently high compared to historic averages.
Q1 2022 alone was marked by big price swings, making the quarter almost 1.5 times as volatile as the median quarter over the past three years for U.S. Large Cap Equities – with volatility persisting well into June.2 We believe volatility will stay above its historical average for a significant period of time according to the 10-15 year forward-looking outlook in our latest Long Term Capital Market Assumptions.
Market volatility is spiking
…as the rolling three-year S&P 500 Index volatility clearly shows
One silver lining is that higher volatility means you have more opportunities to potentially capture (i.e. 'harvest') losses and generate tax deductions.
How tax loss harvesting works, at its simplest, is this: In order to realize a loss for tax purposes, you have to sell the investment for a price lower than what you originally paid. Then, if you like the investment and/or want to preserve your portfolio’s asset allocation so you might capture potential long-term investment upside, you can purchase a similar investment. However, when making this replacement purchase, be mindful to not violate the wash-sale rule.3
For example, say that in January 2020, you purchased $100K worth of Stock A. After news of the pandemic hit, its value plummeted to $60K.
If you quickly sold Stock A at its new valuation of $60K, you could have realized a short-term tax loss of $40K. That $40K in losses could offset $40K worth of short-term gains made in other parts of your portfolio in 2020 or any subsequent year4, which would be worth up to $16,320 of potential federal income tax savings.
Because you want to keep your portfolio aligned to your objectives, you choose to reinvest the $60K of proceeds from selling Stock A by purchasing Stock B, which has similar characteristics (but is not substantially identical so you don’t violate the wash-sale rule).
With your ownership of Stock B, you’d be able to benefit from this market sector’s recovery from the pandemic a year later. So, hypothetically, you entered February 2021 with Stock B worth $100K after the recovery, but you also saved up to $16,320 on your 2020 federal income tax bill, which means more money that you could use to invest.
Stock A may have similarly rebounded to a $100K value by February 2021–but if you simply held on to Stock A all along, you wouldn’t have generated the tax benefit.
How to turn a stock market loss into a positive—by tax loss harvesting
Now, imagine this tax loss harvesting strategy applied to a substantial portion of your portfolio.
If $10mm of your overall portfolio is invested into a tax loss harvesting strategy, 1% of tax benefit would mean $100K in potential annual savings on that year’s income tax bill.
The power of tech-enabled tax-smart investing
Due to the effort it takes to tax loss harvest—selling, identifying a suitable replacement stock, being mindful of the wash-sale rule, and tax reporting—many people historically harvested their losses just once a year, usually at the end of the year when finalizing all taxable activity for the tax year. But waiting meant they missed harvesting all those market dips during the year from which their stocks recovered by year’s end.
Innovations in technology can help you take full advantage of year-round tax loss harvesting, by systematically capturing losses to offset gains, now or in the future, all the while staying close to your objectives.
You can easily make ongoing tax loss harvesting a feature of how your portfolio is managed. And if you’re going to, you might want to do it right now in this period of market turbulence–as optimizing after-tax returns can really make a difference in how much of your returns you get to keep.
We can help
You’re not alone in navigating the markets. Speak with your J.P. Morgan team about how tax loss harvesting strategies can help you meet your goals.
2 Source: Bloomberg Finance L.P.
3 Generally speaking, this rule prevents you from claiming a current tax loss if you buy a security considered “substantially identical” within a 30-day period before or after the loss trade date. Internal Revenue Code, Section 1091. Instead if the wash sale loss disallowance rule is invoked, you must adjust basis in the replacement security for the disallowed loss which is effectively deferred until the replacement security is sold.
4 After offsetting capital gains, individuals can use up to $3,000 of net capital losses can be used to offset ordinary income, with any amount not utilized carried forward indefinitely. Potential tax savings calculated assuming a $40,000 short-term capital loss from selling Stock A, with that loss offsetting other realized short-term capital gains taxable at a 37% marginal federal income tax rate and subject to the 3.8% surtax on net investment income. State income taxes were not considered. Note that actual tax savings may be higher or lower depending on your individual circumstances.
Tax-loss harvesting may not be appropriate for everyone. If you do not expect to realize net capital gains this year, have net capital loss carryforwards, are concerned about deviation from your model investment portfolio, and/or are subject to low income tax rates or invest through a tax-deferred account, tax loss harvesting may not be optimal for your account. You should discuss these matters with your investment and tax advisors.
JPMorgan Chase & Co., its affiliates, and employees do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal and accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any financial transaction.