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Tax loss harvesting activity scales with tax bracket; also, TLH can coexist with external holdings

Summary

The lower the account holder's tax bracket, the less the benefit from TLH will be. We consider the tax bracket when deciding how aggressively we should harvest losses, instead of treating TLH as an on/off feature and always doing the same actions when it is turned on.

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

Higher tax rates will of course result in lower after-tax performance than low tax rates; see here. Pre-tax performance (labeled "All") will actually be better in the high-tax scenario (see here). There are bigger TLH opportunities, and therefore larger tax refunds, but there are no offsetting taxes on unrealized gains, because pre-tax numbers intentionally ignore that.

There are also more TLH opportunities at higher tax rates, because price declines translate more easily into tax savings. In this scenario, there are 8 days with TLH trades in the high tax vs. 5 days in the low tax scenario.

Conclusion

Our tax loss harvesting will correctly adjust its behavior based on a client's tax bracket.