Make market volatility work for you by turning today’s losses into tax breaks that can boost portfolio returns this year, and in years to come.

June 22, 2022

As painful as market gyrations have been, the silver lining is that volatility has made 2022 an ideal year for harvesting losses. Tax-loss harvesting means selling underperforming assets at a lower price than you paid for them to create a tax loss that can offset realized capital gains this year, or any time in the future, in any part of your portfolio.  

Tax-loss harvesting is part of regular portfolio management and usually takes place when wealth managers rebalance asset weightings in client portfolios. But this year an increasing number of investors are turning to customized Tax-Managed Equity (TME) strategies specifically designed to optimize tax-loss harvesting during periods of volatility.

Here’s how tax-loss harvesting works generally, as well as details of how a more powerful TME strategy can be an important alpha-generating tool in today’s volatile environment.

How tax-loss harvesting works

The concept of tax-loss harvesting is simple:

• Sell an asset at a price below what you paid for it to intentionally generate a loss.
• Use that loss to offset realized capital gains in any area of your portfolio – stocks, bonds, or alternatives.  
• If losses exceed gains in a given tax year, the surplus can be used to offset up to $3,000 of your ordinary taxable income, if you are married and filing jointly. Excess yearly losses can also be carried over indefinitely, reducing tax liabilities on capital gains and/or income in future years.
• Use the proceeds of the sale of an underperforming stock to buy something else that’s similar enough to maintain your desired portfolio allocation, making sure to avoid “substantially identical” investments under the IRS’s Wash Sale rules, which may disallow your loss.

The tax treatment of capital gains is determined by the length of time a security is held in an investment portfolio. Short term gains – those investments held for less than a calendar year – are taxed at your marginal income tax rate, the maximum being 37%. But long-term capital gains, arising from selling investments purchased more than a year ago, are generally taxed at a maximum rate of 20%. Because of the more onerous tax treatment on short-term gains, they are typically offset with losses before long-term gains.

There is an additional income tax of 3.8% that’s applied to capital gains (both short-term and long-term) for single filers with taxable income over $200,000, and jointly filing married couples earning over $250,000.

There is a logic to the use of losses. Typically, like-losses offset like-gains. For example, you would offset long-term gains with long-term losses and short-term gains with short-term losses. If there is still a net gain in one and a net loss in the other, then you can use the surplus losses to offset those remaining gains.

Tax savings can be significant

To appreciate the savings that can come from tax-loss harvesting in a year like this, imagine that it’s the end of 2022 and your portfolio is overly exposed to energy. To get your portfolio back to a preferred allocation, you may decide to sell some energy stocks bought in January 2022 and realize a $50,000 short-term capital gain. 

Let’s assume you also bought some stocks in the consumer discretionary and technology sectors in January, which are now trading lower than their purchase price, so you decide to sell them and realize a $75,000 loss.

In this case (illustrated in Exhibit 1), you would first use $50,000 of that short-term loss to offset the $20,400 tax paid on the short-term $50,000 gain (at a tax rate of 37% plus 3.8%). There are no long-term realized gains to offset, so if you are a married couple, you can use $3,000 of the remaining $25,000 of tax losses to reduce joint ordinary income. That would save you $1,224 in taxes (again at the maximum 37% tax rate, plus 3.8%).

At the end of the day, that means you’ve cut your tax bill by $21,624, and still have $22,000 of losses left to carry over into 2023 (and beyond). Those losses can be used to offset gains realized in any part of your portfolio, or income in the case of married couples.

Exhibit 1: Using Stock Losses to Offset Taxable Capital Gains