Tax-loss harvesting and direct indexing can help mitigate tax liabilities and grow wealth, especially amid market volatility.
In brief
- In volatile markets, tax-loss harvesting can offer an opportunity to realize a benefit from what may otherwise be challenging times.
- Tax-loss harvesting can be key to preserving pre-tax returns by mitigating tax liabilities, and volatile markets present a unique opportunity to do this.
- A continuous approach to tax loss harvesting, which takes advantage of daily stock-level volatility, is particularly important to capture tax losses when and where these opportunities arise.
- By investing in a direct indexing strategy that offers this type of approach, advisors can help investors retain and grow their wealth over time.
In the dynamic world of financial markets, volatility is a constant factor that can unsettle even the most seasoned investors. While turbulent times can create a behavioral challenge for them, and make it hard for investors to remain invested over time, they also create opportunities for tax-loss harvesting.
The case for continuous tax-loss harvesting
Many financial advisors recognize the value of tax-loss harvesting as a means to mitigate tax liabilities and preserve and grow wealth in investor portfolios. However, the potential for tax savings can be significantly enhanced by adopting a continuous approach throughout the year, reviewing portfolios as frequently as daily rather than waiting until year-end to see what opportunities may be available. By consistently monitoring stock-level volatility on a systematic basis, investors can be better prepared to realize losses whenever market fluctuations occur, thereby reducing their tax bills more effectively than an annual approach.
Historically, tax-loss harvesting has been a manual and time-consuming process. However, advancements in technology now enable direct indexing strategies to automate this process, allowing for more frequent and systematic tax-loss harvesting without manual intervention. With the right safeguards, a continuous approach can provide more opportunities for tax-loss harvesting, consistently adding value across market environments.
Recent market events: Pockets of volatility in 2023 and 2024
The regional banking crisis in 2023 and the volatility experienced in August of 2024 serve as recent examples of how market events can create tax-loss harvesting opportunities intra-year or even intra-month. The regional banking crisis in March 2023 demonstrated a period where losses could be taken multiple times within a short period of time. The S&P 500 ended March 2023 up 3.37%, yet intra-month volatility presented tax-loss harvesting opportunities that may have been missed without continuous reviews. Those losses could have been used to offset gains, reducing the overall tax burden for investors.
Similarly, in 2024, the market experienced significant fluctuations, particularly in early August. These conditions offered investors a chance to realize losses before the market quickly rebounded, provided they had access to a continuous tax-loss harvesting approach.
To further illustrate this point, in the case studies for a $1 million representative account below, we harvested losses 12 times in 2023 and 10 times in 2024.
While these periods are prime examples of how market events can create tax-loss harvesting opportunities, it’s important to recognize that these events are not anomalies. Opportunities for tax-loss harvesting can occur in any market environment, whether during periods of significant upheaval or in more stable times.
A robust process for success
To effectively implement a continuous tax-loss harvesting strategy, a systematic and robust process is essential. This process involves several key components, which are often incorporated into direct indexing strategies:
- Cost-benefit analysis: Evaluating the optimal threshold for realizing losses is crucial to prevent unnecessary portfolio turnover. By carefully assessing the cost versus benefit of each trade, investors can maximize tax savings without compromising portfolio integrity.
- Wash sale compliance: Monitoring for wash sale violations is vital, as these rules disallow the same security from being sold and repurchased within a 31-day period. A focus on compliance helps maintain the eligibility of realized losses for tax purposes.
- Up-to-date pricing data: Utilizing start-of-day pricing data allows for informed decision-making about realizing losses. This data ensures that tax-loss harvesting decisions are based on current market conditions, as compared to using closing prices from the previous day.
Efficiency in tax management not only frees up time for financial advisors but also has the potential to produce more tax savings for clients. By increasing the frequency and volume of tax-loss harvesting opportunities, direct indexing and a daily approach can add significant value to an investor's portfolio, setting them up to capitalize on market volatility.
In conclusion, asset managers can alleviate client concerns by systematically utilizing tax-loss harvesting, helping clients remain committed to their financial plans. A continuous tax-loss harvesting strategy - supported by direct indexing and advanced technology - can enhance after-tax returns. Embracing these strategies can help position financial advisors to deliver significant value during turbulent times.