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Taking Tax-Loss Harvesting to the Next Level

 The empirical research has shown that tax-loss harvesting strategies in separately managed accounts can improve the post-tax returns of an investment portfolio by employing a strategy of selling positions in securities with losses in order to generate capital losses that can be used to offset gains generated in the overall portfolio. The Internal Revenue Code permits capital losses to be netted against capital gains in the year they occur. Unused losses can be carried forward indefinitely, deductible against future net capital gains plus an additional $3,000 deductible against ordinary income per year.

Since long-term capital gains are often taxed at lower rates, a tax-loss harvesting strategy can improve a portfolio’s after-tax performance. While long-term losses are generally hard to realize systematically because stock positions on average appreciate over time, in the short term, volatility allows for the capture of short-term losses. The result is that most losses end up being short-term, which can be used to offset highly taxed short-term gains. With that said, most of the benefit from tax-loss harvesting is from the deferral of gains (offsetting realized gains from other assets in the portfolio).

 A key benefit of tax-loss harvesting is that it can allow investors with concentrated positions in low-basis stock to diversify their holdings as tax-loss harvesting losses are realized—the losses are used to offset some, or all, of the taxes due on the sale of the low-basis stock. It can also help offset the capital gains taxes generated by less tax-efficient (higher turnover) equity strategies such as those of active managers.


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