The questionable benefits of tax-loss harvesting: Larry MacDonald

 
(Photo: Nick M Do/Getty Images)
(Photo: Nick M Do/Getty Images)

Tax-loss harvesting is a popular strategy, particularly as the year end approaches. But many investors, advisers, and financial writers don’t seem to be aware that the benefits of this widely accepted practise are often miniscule or even negative—as highlighted in analyses such as “Costly Harvest.”

Tax-loss harvesting involves selling a taxable investment showing a capital loss and repurchasing it after the 30-day superficial-loss rule, or else immediately buying a different, but correlated, investment. The capital loss is then claimed against capital gains to reduce taxes.

At first glance, this strategy may appear to reduce taxes and boost after-tax returns. But, in reality, it merely defers tax to future periods and leaves after-tax returns unchanged over the long run.

That’s because tax-loss harvesting re-sets the price of the investment to a lower level. So when the time comes to dispose of it for good, the reported capital gain will be bigger than if the investor had just bought and held. The extra tax on this bigger gain offsets the tax savings earned from the tax-loss sale.

To see why, consider the following situation. An investor in the 33% tax bracket puts $100,000 into an investment fund held in a taxable account. It declines to $70,000 but rebounds over the ensuing years to $140,000, where it is sold to help fund retirement.

The buy-and-hold investor pays tax on a capital gain of $40,000, which amounts to $6,600 ($40,000/2 x 0.33).

The tax-harvesting investor first sells at $70,000 to claim a capital loss and receive a tax refund of $4,950 ($30,000/2 x 0.33). Then they sell at $140,000, realizing a capital gain of $70,000 on which tax paid is $11,550 ($70,000/2 x 0.33). Netting out the earlier tax refund, final tax paid is $6,600—the same as the investor who held throughout.

So, tax is only deferred. True, some investors may still be attracted to tax-loss harvesting because it’s like getting an interest-free loan that is paid off in inflation-depreciated dollars. But when interest rates and inflation are at very low levels like now, this benefit is rather small.

Moreover, for many investors, there is a material risk that tax rates can go up after a tax-loss sale made. If this happens, tax-loss harvesting will result in paying more taxes than simply buying and holding.

To demonstrate, let’s extend the above example: say the tax rate rises to 50% after the tax-loss sale. When the position is closed for good by the tax-loss harvester at $140,000, gross tax paid is $17,500 ($70,000/2 x 0.5), leaving net tax of $12,550 after deducting the earlier tax saving. The buy-and-hold investor, however, ends up paying lesser taxes of $10,000 ($40,000/2 x 0.5).

The risk of higher tax rates should not be underestimated. Tax rates usually increase with age as people win job promotions or retire with ample RRSPs that need to be converted to RRIFs (which require mandatory withdrawals at high rates). Also, financially strapped provincial and federal governments could bring in higher statutory tax rates in years ahead.

There may be some situations where the benefits of tax-loss selling are salient: notably, an investor may know with certainty that they’ll be in a lower tax bracket in the future. Or they are donating to charity (in which case the deferred taxes are never paid). But for many investors, the benefits of tax-loss harvesting could turn out to be a lot less than expected.

 Larry MacDonald is a former economist who manages his own portfolio and writes on investment topics. He is the author of several business books

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