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Simple pairs-based tax-loss harvesting (TLH) increases after-tax returns

Summary

After-tax returns are higher when we apply a simple ETF-pair-based tax loss harvesting strategy. We are not the only ones who can do this, but we have the ability to display an individualized benefit to clients based on their tax bracket, external holdings, etc.

Background

Tax loss harvesting (TLH) is a passive investing strategy (i.e. has no opinion on which way prices will go) which increases after-tax returns in taxable accounts.

The most commonly implemented TLH strategy is a simple one based on pairs of ETFs. We choose a pair of ETFs (per asset class) which are:

A good example is two ETFs that track the 500 and 1000 biggest US stocks, respectively. In practice, their prices move almost in unison. However, they are not "substantially identical" per the wash sale rule.

Pairs-based TLH monitors ETFs trading at a capital loss. When the price of an ETF held in the account has declined enough where it would generate a tax loss above a (configurable) threshold, it is sold and replaced by purchasing the similar ETF in the pair. This maintains the desired asset exposure, while "harvesting" a tax loss.

After-tax returns are higher because it is almost always better to postpone tax payments for later:

[Note: Things get more complicated due to an annual limit of tax losses that can be claimed against ordinary income, but there are often enough capital gains in high-end accounts from other sources (e.g. sale of a home) that the full amount of harvested losses will reduce tax liability.]

Of course, in the few cases where it is not better to postpone taxes, or if the client does not want it, TLH can be disabled.

Scenario parameters

Results

The fairest way to compare the results with vs. without TLH is to look at the after-tax liquidation values. TLH works by realizing losses today at the expense of postponing gains. We cannot ignore the fact that tax would have to be paid at some point, because it would make TLH look even better than it is.

We display totals using three sets of liquidation assumptions:

  1. All: unrealized tax never has to be paid.
  2. All (after tax): any tax owed at any given point in time gets subtracted from the final value.
  3. All (after tax; ST taxed LT): long-term tax rates are applied even to short-term gains / losses. This metric is less realistic; however, we prefer it, because it avoids abrupt value changes around the days when short-term tax lots become long-term, such as one year after a large investment.
Note how the black line (TLH enabled) is higher than the light gray line (TLH disabled) using either All (after tax) or All (after tax; ST taxed LT). If we search for "money-weighted returns" in the data grids for TLH disabled vs. enabled, we can see the annualized difference is 1.26% for pre-tax and 0.44% for after-tax returns, in this particular example. This demonstrates that even after-tax portfolio returns are higher with TLH, not just the pre-tax returns.

It is also interesting to compare the Net taxes owed tabs, or view the difference in a single chart here.

This indicates that the TLH approach has paid fewer taxes, since more taxes have been deferred. Of course, all else being equal, it is better to owe fewer taxes than more. However, in this case, more tax owed is a worthwhile price to pay because the increased portfolio returns more than make up for it.

Conclusion

Most automated advisors offer this simple strategy; however, we have the ability to display what happens based on a client's tax bracket and other inputs (deposit patterns, fees charged, external holdings, etc.)