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Tax-Loss Harvesting: Should Investors Believe The Hype?

Aug. 03, 2018 6:27 AM ET1 Comment

By David Allison, CFA, CIPM

Do tax-loss harvesting strategies boost after-tax returns?

Many hypothetical, backtested performance claims imply that they do - and by a lot. But advisers should think twice before using these claims to set client expectations. The value added by such strategies depends on future market environments and an investor's circumstances.

In "Tax Management, Loss Harvesting, and HIFO Accounting," Andrew L. Berkin and Jia Ye highlight how market environments, portfolio cash flows, and tax rates influence the effectiveness of tax-loss harvesting strategies. They conclude that markets with higher stock-specific risks and lower average returns offer the most fertile ground for such strategies. They also show that a steady stream of contributions reinvigorates a portfolio and helps maintain the benefits of tax-loss harvesting over time. On the flip side, large withdrawals are counterproductive to such strategies, while the advantages tend to be related to an investor's tax rate on a roughly linear basis.

These findings suggest that tax-loss harvesting's potential benefits depend on an investor's financial situation and must be weighed against the risks.

Harvesting a loss might generate tax savings today, but it reduces the cost basis of the investment and could raise future tax liability. If the investor's tax rate increases in the future, the tax deferral benefit of the harvested loss could diminish. Conversely, if the tax rate decreases, the deferral benefit could be amplified.

Many pro-tax loss harvesting studies assume the investor's tax rate remains stable over time. This is often unrealistic. Rates can change drastically based on shifts in policy or life events. Current federal income tax rates in the United States are scheduled to sunset after 2025, which may mean higher marginal tax rates. Jason Zweig demonstrates how harvesting losses can backfire if tax rates go up in the future. The

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