The dramatic market downturn at the end of the first quarter of 2020 presented numerous opportunities to conduct tax loss harvesting in investor portfolios. The market rebounded within a few months, however, and then rose even higher, leading to a dearth of opportunities to tax loss harvest since then.

While tax loss harvesting is generally the technique that is most helpful in enhancing after-tax returns for investors, it isn’t the only one. After-tax returns can also be enhanced by deferring the realization of gains until they are long-term. A short-term gain is taxed at the higher ordinary tax rate rather than the lower capital gains rate. For investors in the highest income bracket the federal tax rates that would apply are 40.8% for short-term gains and 23.8% for long-term gains, a substantial difference.

The Long and Short of It
The market events of a year ago, and the very strong returns since then, have generated many opportunities to help boost after-tax returns by customizing the timing of investment actions in client accounts. Last year around this time we saw a big increase in activity in accounts due to manager decisions (buying new stocks at very attractive valuations) and rebalancing (re-allocating from fixed income into equities). Now, many stocks have rebounded and managers are looking to take profits and move into other investment opportunities. Unfortunately, in many cases the positions have been held for less than a year, and doing so would result in short-term gains.

Below we’ve highlighted a few real-life examples that illustrate how customizing the timing for individual client accounts and deferring trades that would generate short-term gains can help improve after-tax outcomes.

Example 1
A manager initiated a buy of a financial technology firm in March 2020 at an average price of $98.20. In February 2021 the manager decided to sell the position. In tax-exempt accounts we sold the shares immediately at a price of $145.29, 48% higher than the purchase price. In taxable accounts, however, we deferred the sale in accounts that were getting close to the one-year holding period. In those accounts we sold the stock in March at a price of $144.88, which is 47.5% higher than the original purchase price. While there was a modest decline in that pre-tax appreciation, the benefit after tax is substantial. Selling in February would have generated a short-term gain and the after-tax appreciation would have been 28.4%. Waiting until March resulted in realizing a long-term gain and the after-tax appreciation improved to 36.2%.

  Purchase Price Sale Price Pre-tax Appreciation After-tax Appreciation
February sale
$98.20
$145.29
48.0%
28.4%
March sale
$98.20
$144.88
47.5%
36.2%

Example 2
The sharp decline in equity markets in Q1 2020 led to the rebalancing of many accounts from fixed income into the equity sleeves in mid-March 2020, resulting in purchases of a Germany-based good processing company in most client accounts allocated to a specific international strategy. In early March 2021 that manager initiated a sale in the stock that would have resulted in short-term gains for taxable clients. Trades were deferred on these shares for those clients. As shown in the table below, clients benefited from greater after-tax appreciation as a result of the trade deferral (67.7% versus 52.2%).

  Purchase Price Sale Price Pre-tax Appreciation After-tax Appreciation
Early March sale
$20.21
$38.03
88.2%
52.2%
Mid-March sale
$20.21
$38.16
88.8%
67.7%

Example 3
Another manager purchased shares of a Swiss airport operator in mid-March 2020 and then decided to take profits in that stock in mid-March 2021, slightly less than a year after the initial purchase. While deferring the sale for taxable accounts resulted in a decrease in the sale price (the stock dropped from $7 to $6.71), the after-tax appreciation realized by clients on these shares was still substantially better (45.6% versus 39.5%).

  Purchase Price Sale Price Pre-tax Appreciation After-tax Appreciation
Mid-March sale
$4.20
$7.00
66.7%
39.5%
Late March sale
$4.20
$6.71
59.8%
45.6%

Over the long term, tax loss harvesting tends to be the tax management technique that helps the most in improving after-tax client returns. The amount of tax loss harvesting in accounts varies quite a bit, however, and is higher in periods of market downturns. When market returns are strong, other techniques such as deferring short-term gains and choosing the optimal tax lots can play a larger role in boosting after-tax returns.

As with other tax management techniques, effectively implementing this strategy requires the ability to customize decisions at the individual account level. Clients’ purchase dates and cost basis may vary, leading to different outcomes and optimal implementation approaches for each client.
The views and opinions expressed may change based on market and other conditions. This material is provided for informational purposes only and should not be construed as investment advice. There can be no assurance that developments will transpire as forecasted. Actual results may vary.

Natixis Investment Managers does not provide tax or legal advice. Please consult with a tax or legal professional prior to making any investment decisions. Every situation is unique and this does not constitute tax advice. Please consult with your tax advisor. Future tax rates and rates of return are unknown and will affect your personal outcome.

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