Tax loss harvesting activity scales with tax bracket; also, TLH can coexist with external holdings
Summary
The lower the account holder's tax bracket, the less beneficial TLH will be.
We consider the tax bracket when deciding how aggressively we should harvest losses,
instead of treating TLH as an on/off feature and always doing the same actions when it is turned on.
Background
Tax loss harvesting (TLH) is a passive investing strategy
(i.e. has no opinion on which way prices will go) which aims to increase after-tax returns
in taxable accounts.
The most commonly implemented TLH strategy is a simple one based on pairs of ETFs.
We choose a pair of ETFs (per asset class) which are:
similar enough that they both track their corresponding asset class very well
different enough to avoid triggering the IRS wash sale rule,
which disallows you from claiming a tax loss if you buy a "substantially identical" security within 30 days
of having sold it at a loss.
cheap enough to trade (small spread)
cheap enough to hold (low expense ratio)
A good example is two ETFs that track the 500 and 1,000 biggest US stocks, respectively.
In practice, their prices move almost in unison. However, they are not "substantially identical" per the wash sale rule.
Pairs-based TLH monitors ETFs trading at a capital loss.
When the price of an ETF held in the account has declined enough
where it would generate a tax loss above a (configurable) threshold,
it is sold and replaced by purchasing the similar ETF in the pair.
This maintains the desired asset exposure, while "harvesting" a tax loss.
After-tax returns are likely to be higher because it is almost always better to postpone tax payments until later:
"Time value of money": The money that would have been paid in taxes upfront gets to grow with the market.
For investors who will be in a lower tax bracket when they sell their assets later in life, they will owe less tax.
[Note: Currently, assuming the tax law does not change, this benefit would be biggest for short-term capital gains,
which get taxed at ordinary income rates, which can drop a lot during retirement.
However, for a scenario of selling assets in retirement,
the benefit effectively applies only to long-term capital gains,
where the differential would be limited to a possible avoidance of the 3.8% Medicare surtax.]
There are cases where no tax is owed at all, e.g. when assets are passed down to someone's heirs,
or in a charitable contribution.
[Note: Things get more complicated due to an annual limit of tax losses that can be claimed against ordinary income,
but there are often enough capital gains in high-end accounts from other sources (e.g. sale of a home)
that the full amount of harvested losses will reduce tax liability.]
Of course, in the few cases where it is not better to postpone taxes, or if the client does not want it, TLH can be disabled.
Scenario parameters
Held by us: $1,000,000 in cash, which we are free to invest
External: we have an external $250,000 position in VIG (Vanguard Dividend Appreciation ETF).
Even though this is not the main point here, this shows we can handle external assets in parallel with TLH.
Target allocation: in both cases, a balanced mix of
7 asset classes
Tax: We consider two tax scenarios; a high-tax scenario, and a low-tax scenario
in which all tax rates are cut in half compared to the high-tax one.
Results
Higher tax rates will of course result in lower after-tax performance than low tax rates; see
here.
Pre-tax performance (labeled "All") will actually be better in the high-tax scenario (see
here).
There are bigger TLH opportunities, and therefore larger tax refunds, but there are no offsetting taxes on unrealized gains,
because pre-tax numbers intentionally ignore that.
There are also more TLH opportunities at higher tax rates, because price declines translate more easily into tax savings.
In this scenario, there are 4 days with TLH trades in the
high tax vs. 2 days in the
low tax scenario.
Conclusion
Our tax loss harvesting will correctly adjust its behavior based on a client's tax bracket.
