Why Tax-Loss Harvesting During Down Markets Isn’t Always A Good Idea

Why Tax-Loss Harvesting During Down Markets Isn’t Always A Good Idea

During market downturns, tax-loss harvesting is often considered a ‘silver lining’ to an otherwise undesirable situation. In theory, the strategy allows investors to convert their capital losses into a tax deduction while staying invested so they can benefit when markets recover – ostensibly a win-win for the investor and, consequently, a popular strategy for advisors who are often eager to find ways to provide extra value to their clients in volatile markets.

But contrary to this no-lose framing, there are situations where tax-loss harvesting results only in a net neutral outcome for the investor, and can even leave the investor worse off than if they had done nothing to begin with! This is because when losses are harvested, the investor’s cost basis in their portfolio is reduced by the amount of the loss. Which means that when the investment is ultimately sold (after it has recovered to or above its original value), there will be an additional capital gain equal to the loss that was harvested earlier – potentially negating some (or all!) of the initial benefit of harvesting the loss in the first place.

Whether tax-loss harvesting benefits the investor or not, then, depends highly on the investor’s tax rate when they deduct the initial loss, as well as the rate at which they realize the later gain that the initial loss created. If the investor is taxed on future gains at a lower rate than losses harvested today, the resulting ‘tax bracket arbitrage’ can create a net tax benefit. But the effect can also work in the opposite direction, and when the future gain is taxed at a higher rate than the loss today, the investor might be better off doing nothing (and not harvesting the loss), as in some cases, the additional capital gains created by harvesting losses could themselves push the taxpayer into a higher future tax bracket.

Additionally, when the goal of the investor is to build wealth, harvesting losses can be counterproductive if the investor doesn’t reinvest their initial tax savings because – along with losing out on the potential growth of that savings – spending it all upfront potentially requires the investor to pull additional funds out of their portfolio later on in order to pay for the extra capital gains created by harvesting the loss. And when the investor has large carryover losses from previous years that potentially won’t get used during their lifetime, tax-loss harvesting might potentially just create additional carryover losses, which are lost when the taxpayer dies and the cost basis is stepped down.

Ultimately, the value of tax-loss harvesting has a lot to do with an individual’s current and future circumstances, and financial advisors can take advantage of their knowledge of their clients’ financial pictures to identify when harvesting losses might be (or not be) a good idea. By taking the time to analyze the value of tax-loss harvesting – beyond the upfront tax deduction – advisors can help clients make well-thought-out choices about tax-loss harvesting that make them more likely to benefit from it in the long run.

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