2020 has been a difficult year, most notably because of the coronavirus. While the pandemic has first and foremost been a human tragedy, it’s also had a devastating impact on the global economy and on financial markets. On the flip side, it’s also opened a potential opportunity for tax-efficient investing.
The sting of stocks’ sharp declines in late February through mid-March was eased somewhat by the market’s subsequent comeback; however, the recovery was only a partial one for many equity indexes as of mid-June.1 The anxiety that investors have experienced can be seen in the Cboe Volatility Index, a gauge of expected stock market volatility over the next 30 days. As of mid-June, the so-called VIX was well below the record level that it had set in mid-March but above its historical average.2
For investors with assets held in taxable accounts, today’s heightened volatility offers a unique chance to enhance after-tax returns by reviewing potential tax-loss harvesting opportunities within portfolios. After all, it’s not just about your investment returns; it’s what you keep after taxes.
Equities’ generally positive returns in the recently ended bull market that started in early 2009 haven’t offered many chances for investors to book tax losses to help offset taxable capital gains elsewhere in their portfolios from holdings that gained value.
Where to search for tax-loss harvesting opportunities
While it’s hard to say at this point whether 2020 will end up as a positive or negative year for equities, the speed and breadth of the recent market decline opened the door to potentially harvest losses at midyear in many asset classes, particularly in sectors that have underperformed year to date. As of mid-June, energy, financials, and industrials were the weakest-performing sectors in the S&P 500 Index; other segments that lagged by wide margins included small- and mid-cap stocks and, in terms of equity style, value stocks trailed their growth counterparts.1 These may be areas of a portfolio to target when searching for holdings that may present tax-loss opportunities if they’re sold to help offset tax liability from investments that trigger capital gains.
On the flip side, information technology sector holdings and growth stocks have outperformed this year, extending a long stretch of strong results for those segments.1 Those results may have left some investors with more portfolio exposure to tech and growth stocks than they had anticipated. Indeed, a portfolio review for tax-loss harvesting opportunities can be done in tandem with a rebalancing effort to restore a portfolio to the exposure parameters that an investor may have established as part of a long-term plan.
The potential benefits of tax-loss harvesting
Coming after the stock market’s rise in the now-expired bull market, there’s a high likelihood that investors will continue to be hit with tax bills from capital gains generated by investments held in taxable accounts. (In tax-deferred accounts, such as IRAs or a 401(k)s, capital gains aren't taxable for the year the gain occurred.) Capital gains are triggered as portfolio managers sell holdings that have appreciated in value. Investors share the tax burden in the same calendar year that the net gains were realized.
However, taxable exposure from investment income can potentially be reduced through tax-loss harvesting. While this approach can be complicated, it’s simple in other respects. For example, assume a fund holding that declined in value can be sold to generate a pretax loss of $10,000. That loss can in turn fully offset the net capital gain exposure from the sale of another holding whose value increased by $10,000.
What’s more, losses can be used to limit tax exposure from noninvestment income, as well as to offset investment gains. Under current law, a capital loss deduction allows an investor to claim up to $3,000 more in losses than in capital gains, meaning investors can reduce their taxable income dollar for dollar, up to that $3,000 limit. (The limit is $1,500 for a taxpayer who's married and files separately.)
However, any investor selling securities as part of a tax-loss harvesting strategy should trade cautiously. An IRS restriction known as the wash sale rule makes it difficult to realize a short-term benefit from quickly getting back into a mutual fund or security after selling the investment at a loss; the loss can't be deducted unless an investor waits at least 30 days to reinvest in that same investment.
What to look for in the months ahead
Around October or November, asset managers typically provide notices to shareholders to aid in year-end tax planning. These notices, as well as online disclosures, indicate which mutual funds are expected to pay gains by year end—based on market performance at the date the estimates are made, typically through the end of September—and provide estimates of the amounts of those expected gains as well as funds’ estimated income distributions from dividends, interest, and other net income.
Although this preliminary information is subject to market movements in the closing months of the year, early estimates provide an opportunity to evaluate potential tax liability and, if merited, adjust accounts accordingly through strategies such as tax-loss harvesting. While asset managers typically don’t distribute late-year estimates of funds expected to generate losses, identifying such funds isn’t difficult; year-to-date performance figures are widely available on the websites of asset managers and research firms, as mutual funds are required to publish share prices each business day.
A good time to check in with your financial or tax professional
The recent surge in market volatility may ultimately prove to be a mere bump in the road for investors who stay in the market for the long haul. However, now may be a good time for investors with taxable accounts to check in with a financial professional to review investment goals and discuss tax-loss harvesting opportunities. Professional advice can be especially valuable when it comes to something as potentially complex as tax-loss harvesting, as there’s no guarantee that such a strategy will achieve any particular tax outcome or that it will be in an investor’s best interest over the long run. As always, the John Hancock Investment Management tax center has resources designed to help make your tax planning easier, including a schedule of 2020 tax rates and limits, tax forms, and more. The power of professional advice and solid information can go a long way toward helping to maximize an investor’s tax efficiency.
1 S&P Dow Jones Indices, as of 6/12/2020. 2 Cboe Exchange, Inc., as of 6/12/2020.