The markets have been wildly volatile this year – there is no debating this fact, it is what it is. Oftentimes during turbulence in the markets, people have an urge to get out, cut bait, sell their holdings and sit ‘safely’ in cash, with the intention of buying back in when the markets start to recover. There are a multitude of reasons why, historically, this has been an unsuccessful course of action. Perhaps even more importantly, it negates any possibility of implementing effective Tax Loss Harvesting, which can be a powerful tool for managing taxes.
Exiting the market with the intention of jumping back in during rosier times sounds great in theory, but in practice it rarely works out like that. Selling off assets to “sit on the sidelines” in the past has been plagued by problems. Historical data has shown even the best professional investors are mostly unsuccessful at “timing the market” or jumping back in at the right time. You must be right twice in a row to make that process work!
But there is an opportunity in market declines. And, contrary as it may seem, we can actually help to put you in a fantastic position for neutralizing some of your future taxes. We are talking about ‘Tax Loss Harvesting.’
What Is Tax Loss Harvesting?
What does Tax-Loss Harvesting mean? When the value of your investments has declined to the point of generating a loss, we jump in to ‘capture’ them. This means we sell the particular investment that is down (capturing the loss) and simultaneously purchase a similar investment. We want you to stay invested, and we also want to ‘take the loss’. This allows us to do some effective tax management for your account. You may end up seeing loss ‘carryforwards’ on your tax return in a given year. We think of this as ‘putting your losses into a box on the shelf’ that we can take down from that shelf to use in the future.
Additionally, because we reinvest the proceeds back in the market, albeit in a different security but one that still contributes to your overall investment profile, you are not stuck on the sidelines in cash when the markets recover and increase.
Apples and Oranges… and Bananas
Below is a simplified example of how our tax-loss harvesting process works:
Let’s say you have quantities of apples, oranges and bananas, and each bundle of fruit is valued at $100 so your fruit portfolio is sitting at $300 total. Then the demand for apples has gone up 10%, the price for oranges is the same, and for bananas it has gone down 10% so the value of your fruit is as follows:
-
- Apples = $110
- Oranges = $100
- Bananas = $90
Your overall fruit portfolio still has a value of $300 even though the prices for each specific fruit have changed. To tax loss harvest in this scenario, we would sell the bananas for $90, capturing’ a $10 loss. Let’s put that loss ‘into a box on the shelf’.
Time to Harvest Our Tax Losses
Now that we’ve sold the bananas, we don’t want to be just sitting in cash.
-
- When we sell the bananas for $90 at a $10 loss, we could then buy $90 worth of peaches – the value is the same as it was in bananas ($90) it is just in a different fruit (or security)
So now let’s say muddled fruit cocktails become all the rage and fruit as a whole goes up 10% from before. Now our portfolio looks like:
-
- Apples = $121
- Oranges = $110
- Peaches = $99 (Plus, we have now $10 of captured losses just sitting on the shelf at our disposal)
So let’s say you decide to sell Oranges. You would have a capital gain of $10 you would normally pay taxes on. But because we have $10 of captured losses sitting on the shelf, we can offset that $10 gain meaning you pay zero in taxes. If we had stayed in Bananas the value would also have gone back up to $99 just like Peaches, but we would not have captured $10 in losses to offset future gains. This ‘loss on the shelf’ will help to reduce your taxes in the future once you sell off some of your fruit that has gains.
Staying Invested in the Markets
There are some rules that we did not include in the example above, but the prevailing logic is the same.
Our objective is to make sure you stay invested in the markets (never sell out at the bottom!) in order to benefit from the market recovery when it happens. Tax loss harvesting gives us the opportunity to invest you back into the markets and rebalance your accounts in a more strategic, diversified way that is designed to give you benefits now as well as in the future.