Tips for Smarter Tax Trading

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The end of the year often sees investors scrambling for ways to minimize their investment taxes, most often by harvesting losses. But the actions investors take this year will most likely increase taxes paid in future years. And the transactions themselves are rarely costless. The math here is unforgiving. The smaller the loss you harvest, the more likely the transactions are to make you worse off.

00:25 - 00:56

It's better to think about investment taxes year-round so that you minimize realizing capital gains. And there are some other techniques that we recommend that will also minimize your tax bill. Welcome to Bernstein Insights, this is The Pulse where we cover trends in the economy, markets, and asset allocation for long-term investors. I'm Matt Palazzolo, Senior Investment Strategist, and today I'm joined by Director of Research in our Wealth Strategies Group, Tara Thompson Popernic, and Senior Investment Strategist Paul Robertson.

00:56 - 01:14

So, Tara and Paul, welcome to the show. Thanks, Matt. Good to be here, Matt. Towards the end of every year, our clients reach out to us and ask us to take all of the losses in their accounts so that they can offset those losses against gains and reduce their net capital gains so that their capital gains liability is lower in that year.

01:15 - 01:50

Paul, I've often heard you talk about the importance of thinking about after-tax return. Can you just walk through that for our listeners? Yes. I think the crux of the idea here is that in not every circumstance is reducing your tax liability the same as maximizing your after-tax return. OK, so what do you mean by that? To start with a simple example, if I have two investment strategies, two equity strategies that return 25 and 23 percent, respectively, well, based on pre-tax returns, the first strategy, the strategy that earned 25 percent seems the best one.

01:50 - 02:03

But if that strategy generated all of its return in the form of short- term capital gains, and the second strategy didn't generate any realized capital gains at all, then the story is very different. Short-term capital gains are expensive.

02:03 - 02:27

They're taxed at your top marginal rate. So investors in the first strategy are facing a really high tax bill and investors in the second strategy are facing a really low tax bill. So the second strategy would have returned much more after taxes than the first strategy and for taxable investors was the better strategy. This would suggest that reducing taxes is consistent with maximizing your after-tax returns.

02:29 - 02:59

But what if we're comparing now an alternative investment, a private lending strategy that produced a 10-percent return, all in the form of ordinary income, to a municipal bond strategy with a similar risk profile that only generated a 3 or a 4 percent return, but all of it tax exempt? Even for a top tax rate client living in California, that 10-percent return, which would be reduced by taxes to under 5 percent, is still better than the municipal strategy

02:59 - 03:13

that's only returning 3 or 4 percent after-tax. So at the end of the day, it is after-tax returns that matter and after-tax returns are generally improved by paying lower taxes, but not in every case.

03:14 - 03:38

OK, so I think that's a really good example to try and underscore the importance of thinking about investments in after-tax space. I guess, based on your experience, Paul, are there other ways that we think about after-tax returns versus what other investors think about? Yeah, I think the other really big one is the single period perspective versus the multi period perspective.

03:38 - 04:11

When we think about tax management, we're not just thinking about the impact of our actions on this year's tax return. We also think about the impact on future years' tax returns. And obviously what you do this year does impact what happens in the future. If you, for example, have a loss in your portfolio in a stock that would otherwise have been sold next year, but you pull forward the realization of that loss into the present year, well, you've reduced taxes in the present year because that loss is going to offset realized gains in the present year.

04:12 - 04:34

But you're increasing taxes in the future relative to what they otherwise would have been, because that loss would have reduced taxes in future years. But now it's being used to reduce taxes in the present year. Now, of course, moving losses around between different tax years will decrease the taxes in the year that you move them to, and increase the taxes in the year that you move them from.

04:34 - 04:56

But how can we be sure that a stock at a loss in a portfolio today would still be at a loss in the future? I guess I imagine many of our clients have a use-it-or-lose-it type attitude towards these losses. So actually, Matt, you don't have to assume that a loss today is a loss in the future to conclude the loss harvesting today means higher taxes in the future.

04:56 - 05:20

The math here is complicated and I don't want to go through it. But basically, every time you take a loss today, you increase the gap between the cost basis of the portfolio and its market value. And by doing that, you increase future gains. Whether the market is up, whether the market is down, taking a loss today means higher taxes in the future.

05:20 - 05:40

I see Tara chomping at the bit to get in here. So, Tara, let me just pose the question to you. So does this all mean that we don't recommend at all tax loss harvesting? No, every time you can shift a tax bill into the future, you benefit because you're keeping money in your portfolio and working for you instead of having that money go to the government.

05:40 - 06:14

Tax deferral is valuable. The problem is that many investors conflate tax deferral with tax avoidance. And when I say avoidance, that's the idea that you can permanently reduce the tax or make it go away forever. An example of avoidance is holding securities to the long-term cap gains position and holding them for a full year so that you can have better tax treatment on the gain. And I guess what you've avoided there is the short term gain at a higher tax rate. Absolutely. So loss harvesting is not a tax avoidance strategy, as Paul explained, it's a tax deferral strategy.

06:14 - 06:21

Those gains are likely to be realized at some point during your investment lifetime, particularly if you have a very long time horizon.

06:21 - 06:56

So because it's a deferral strategy, not an avoidance strategy, we have to be very clear about the potential costs of the trading to implement the strategy and the impact of the wash-sale rule. OK, I know we're going to get to the costs of implementing that strategy, but you mentioned the wash-sale rule. Let's just clear that for everybody, the wash-sale rule, which means that you have to be out of the stock that you just sold at a loss for 30 days or longer, or your loss is disallowed. Now, obviously, you're taking a risk in being out of that stock for this period, right? What if it does really well over the next 30 days or so?

06:57 - 07:23

Or I guess, Paul, let's come back to you. Are there other costs that you have to be aware of in addition to wash-sale rule and other things? Yes, there are other costs. Our clients aren't charged trading commissions with us, but it's naive to think that that makes trading costless for our clients. There are always bid ask spreads to cross, and there's the potential for even small trading volumes to have some impact on market prices.

07:23 - 07:50

When our clients are loss harvesting in a particular stock, so are many other investors, and the cumulative impact of that pressure often pushes prices down. But then the flip side tends to be true through the wash sale rule period. There's often a reversal in performance and the stock that was at a big loss suddenly does really well. It might be that your replacement stock does really well at the end of the wash-sale rule period, you're often faced with this dilemma.

07:50 - 08:15

Am I going to reverse back out my positions and take a short- term capital gain in the process to get back into the original stock? Because if I do. that short-term capital gain is really going to reduce the benefit of the strategy. So lots of costs here to consider. Yeah, obviously tax loss harvesting is complex. There's as you mentioned, there's these costs to be aware of, the possibility of further cost from being out of your preferred stock and in replacement stocks.

08:15 - 08:48

So when should you actually do this? I mean, when does it make sense to harvest losses and get the benefit from tax deferral and when shouldn't you? Yeah, it, look, it's all about the trade-off between costs and benefits. You only want to engage in these trades if you think the benefits are going to exceed the costs. Now, the larger the loss you're looking to harvest, the larger the benefit of the trade, and the proportionally smaller the potential costs. Now, when we do the math, we think there's a crossover point at losses of around 20 percent. Losses of 20 percent or more

08:48 - 09:09

give you a strong probability that the deferral benefit will exceed the costs of the trade and you'll actually be better off. For smaller losses, there's a real possibility that ultimately the trades will cost you more than the deferral benefit they will create. OK, so I'm fascinated by this 20 percent. Is that a line in the sand? Like what, I don't know, what if it's 19 and a half?

09:10 - 09:36

So, Matt, we did a lot of research into this and it's really about probabilities. At 20 percent or bigger losses, there's a really high probability that the transactions will make you better off. As the loss gets smaller, the likelihood of success falls and the likelihood of failure actually increases. OK, I take your point. So, Tara, I want to come back to you. We obviously, as Paul just said, we'll harvest losses if they exceed or they're around 20 percent.

09:36 - 09:45

What else do we do to try and maximize our clients' after-tax returns? So we think about after-tax returns throughout the year, not just at the end of the year.

09:45 - 10:14

Every single time we trade on behalf of a taxable client, we're asking ourselves if the expected benefit of the trade exceeds its cost, including the tax cost from capital gains. To do that, we track each individual tax lot, cost, and term for every position in a client's portfolio. And that portfolio information combined with client information, tax rate, age, other information gives us the determination about whether or not to trade in a client's account. All right.

10:14 - 10:26

So this customized approach obviously leads to where, I guess, it must lead to different trading decisions and different client accounts and then maybe even within different types of accounts. So maybe talk a little bit about that. Sure.

10:26 - 10:45

So if our portfolio managers decide to sell a stock that has been in some clients' accounts for less than a year, we're likely to implement that trade in non-taxable accounts like IRAs. But in taxable accounts, we're likely to defer the selling of that position until that position goes to a long-term holding period to avoid that short-term gain,

10:45 - 11:18

as I mentioned before. That's the issue about tax deferral, not tax avoidance. Absolutely. So more broadly, the higher effective tax rate that a taxable client has, the more likely we are to defer taking even long-term gains. So, for example, if you have a New York top marginal taxpayer who's very high earner, we're going to try to defer more, even long-term gains in that person's account, compared to maybe a retired person who's living in a low-tax state like Texas, because their effective tax rate is much lower overall.

11:18 - 11:49

Right. So what impact does this have on all of this trading, this customized, very bespoke trading have on the returns for different clients? Does it cause a dispersion from Mrs. Jones's account that owns all the same securities to Mr. Thompson's? So we're trading with the objective that we will have the same pre-tax returns in our client's accounts and the highest after-tax returns we can deliver, given a client's different tax rate, length of time as an investor, their liquidity needs, et cetera.

11:49 - 12:10

So we may do some stuff very differently, even based on someone's age. As clients get older, at age 85, we really slow down the trading because we understand that those accounts may be close to a step up in cost basis ultimately. So there must be other tax management techniques. Let's just round it out, Tara, can you just walk through what else our listeners need to know? Sure.

12:10 - 12:39

So for us, as investors tax management begins at asset allocation. We're building portfolios for the highest after-tax return. Given a client's return requirement, risk tolerance, liquidity needs, and account structure. We have the ability to look over multiple entities when we're tax managing that can roll up to a single taxpayer. And that's critically important when someone has a complex strategy, including multiple trusts and multiple retirement accounts that we have to look at as tax managers, as a single unit.

12:40 - 12:48

We then take a year-round perspective of looking for loss harvesting opportunities. This year, we even started back in the spring. It's not just at year-end.

12:48 - 13:09

We'll only trade and defer those gains in the future when we can find suitable replacement stocks and the benefits are likely to exceed the costs. But let me reiterate Paul's guideline here. Based on our research, we think that there's this crossover point at around 20 percent. It's really all about that probability that the deferral benefit is going to exceed the cost.

13:09 - 13:35

And it comes back to that time and time again. OK, got it. We use tax loss harvesting, but not to the same extent as many other investors because we see it as this deferral strategy rather than an avoidance strategy. And because deferral is not as valuable as avoidance, you need to pursue a big benefit to overcome the actual and I guess the potential costs of harvesting losses. So, Tara, let me just come back to you and then we'll finish up.

13:35 - 13:55

Do we have any tax management techniques that clients, I don't know, might not expect us to be engaging in? We might. And it's really, all depends on a client specific circumstance. In some cases, we may even take gains for clients. So imagine if you're a Florida resident and you're planning to relocate to California.

13:55 - 14:19

Well, it may be worth it for the long-run after-tax return of your portfolio for us to take some gain today and completely avoid that future state income tax on those gains. Other things we may do are halting discretionary rebalancing at year-end. So we may not put your portfolio back to position because we want to defer those gains into the following tax year.

14:19 - 14:52

Specific types of trusts we may tax manage very differently because they are either eligible for additional charitable deductions that we may not be taking full advantage of, or because the beneficiaries of those trusts are looking to avoid short-term capital gains. OK, got it. So obviously, we've covered a lot of ground today talking about all of the elements of tax management and our tax management strategies. This has been very comprehensive. So I want to thank both of you, Tara and Paul, for joining us today and sharing your insights. You're welcome, Matt. Thanks for having us, Matt.

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