When Tax-Loss Harvesting Goes Wrong
Required reading from Kitces Blog
From the Editor
Nearly all research on tax-loss harvesting assumes the highest marginal income and long-term capital gains rates. Only some actually pay these rates. Kitces Blog explores suitability for other brackets, the value of tax-loss harvesting, and when it is not worth the hassle. My goal in highlighting this work is a different perspective on the too-rosy view that all tax-loss harvesting is valuable.
Yet, I have still only scratched the surface. Consumers and their advisers have thoughts on the utility and tradeoffs of adopting direct indexing and tax-loss harvesting beyond the mathematical nuance explored in the following articles. This is a rich topic and an area I am actively researching with polls and dozens of conversations.
Is direct indexing ubiquity inevitable? I’m not so sure.
Tax Tools
Valur: GRAT Calculator
Tax Alpha Weekly
Kitces Blog: Evaluating The Tax Deferral And Tax Bracket Arbitrage Benefits Of Tax-Loss Harvesting
Kitces Blog (Ben Henry-Moreland): Tax-Loss Harvesting Best Practices
Kitces Blog: Is Capital-Loss Harvesting Overvalued?
Kitces Blog (Ben Henry-Moreland): Why Tax-Loss Harvesting During Down Markets Isn’t Always A Good Idea
Leader
In 2014, Kitces looked closely at the value of tax-loss harvesting.
It's crucial to understand cost basis resets lower after harvesting, creating a tax asset now, but increasing future tax liability, all else equal.
EXAMPLE
Original investment: $20,000, now worth $14,000 (30% decline)
Harvesting loss generates $6,000 capital loss Tax savings: $900 (at 15% long-term capital gains tax rate)
Tax alpha: $900 / $14,000 = 6.4% $900
tax savings invested at 8% return = $72 growth in 1 year
On $14,000 investment, true tax benefit = 0.51%
Net benefit 0.44% after tax on growth
Thus, the benefit of tax loss harvesting over time is effectively a “tailwind” of additional economic growth generated as a result of investing the tax savings from the original harvesting transaction. Kitces (2014)
True benefit = compare wealth created by harvesting vs. not harvesting
Long-term excess wealth compounds, but...
...relative returns flatten after investment recovers above original cost basis
30% decline, 7% growth, 15% tax rate: ~0.30%/year additional annualized return.
Higher benefits at higher tax rates (e.g., 0.42% at 23.8% rate)
An example of “tax bracket arbitrage”
Current high tax bracket: 23.8% capital gains rate.
Future lower tax bracket (e.g., retirement): 15% capital gains rate.
$6,000 loss: $1,428 tax savings at 23.8% rate.
$6,000 recovery gain: $900 tax at 15% rate.
Net "free" wealth: $1,428 - $900 = $528
The value of tax bracket arbitrage can be substantial... but is rarely mentioned.
Risk of NEGATIVE tax arbitrage ~ “wealth destructive”
EXAMPLE:
Harvesting $50,000/year for 10 years at 15% rates...
Lowers portfolio cost basis by $500,000
Large recovery gain could push investor marginal dollars into 23.8% tax bracket
Future gains taxed at higher rates, reducing overall benefit
When Tax-Loss Harvesting Hurts
Ben Henry-Moreland’s article gives us even more nuance
Net neutral/negative outcomes: Harvesting losses can sometimes leave investors worse off. Specifically…
Higher Future Tax Rates: If future gains are taxed at a higher rate than current losses.
Future Tax Bracket Increase: When additional capital gains push marginal investor dollars into a higher tax bracket.
Unused Carryover Losses: When carryover losses are not utilized before the taxpayer's death.
Few Actually Pay The Highest Marginal Rates. We Should Stop Assuming Them
Lastly, Some Food For Thought…
Investing in a high-growth business could be more tax-efficient than an IRA. Pre-tax dollars in and capital gains out. Not bad.
