No one roots for their investments to decline. In a perfect world, investors would see gains each time they opened a statement or clicked into their accounts. But in the real world, the economy and markets often run into hurdles. While stocks have historically generated positive returns over the long term, the market can be highly volatile and historical performance is not a guarantee of future success.
With the right management approach, it is possible to turn those temporary setbacks into powerful tax assets, which investors can use to reduce or even potentially eliminate capital-gains taxes on their investments (and potentially even reduce taxes on ordinary income) for years to come.
Tax-loss harvesting is the practice of selling investments that are down in order to realize a capital loss, which may be used to offset taxes in the current tax year or carried forward to use in future years. Using it most effectively can take a fair amount of vigilance and active management to avoid wash sales and to maintain a desired asset allocation. But when it’s done correctly, tax-loss harvesting can be particularly powerful in times of market volatility—letting investors convert temporary market downturns into long-term tax benefits.
While some do-it-yourself investors harvest investment losses themselves, doing so can be complex and challenging.
For example, if an investor sells Company A’s stock at a loss on November 1, they’d have to wait until December 2, at the earliest, to buy it back if they wanted to recognize a tax loss (under the wash-sale rule, investors can’t claim a capital loss on their taxes if they buy the same, or a “substantially identical,” investment in the 30 days before or after the date when they sold a position at a loss). However, if the investor waits until December 2, they run the risk that Company A stages a big rally in the meantime, and they miss it. Between November 1 and December 2 the investor’s asset allocation and risk profile would also be thrown off. If the investor is harvesting losses from multiple positions at once, the complexity only grows.
However, consider whether a professionally managed account could help. If you invest with a managed account solution that uses tax-loss harvesting, such as taxable accounts with Fidelity® Wealth Services, Fidelity® Strategic Disciplines, and Fidelity® Managed FidFoliosSM, your portfolio manager has the ability to harvest losses on an ongoing basis when appropriate—while also striving to maintain the desired diversification and/or asset allocation, thanks to the support of portfolio analytics.2 (Learn more about Fidelity’s managed account solutions.)
“The value of a professionally managed account is we’re evaluating that account every single day,” says Kip Saunders, vice president of Managed Accounts Investment Solutions with Fidelity. “When the market is down, we consider grabbing those losses while keeping the portfolio aligned to the desired diversification and/or asset allocation, so when the market comes back the investor has an appropriate portfolio plus all the benefits of tax losses harvested during the downturn.”
How professional managers harvest losses
Key to effective tax-loss harvesting is keeping the portfolio’s asset allocation and risk profile on track while harvesting losses. In a Fidelity managed account that employs tax-smart strategies,2 portfolio managers accomplish this by swapping in an investment (or a group of investments) that has similar risk and return characteristics to the one that’s sold at a loss, but that isn’t “substantially identical” for tax purposes.3
For example, if an account is invested in individual stocks, managers could sell one stock at a loss and buy another in the same industry with similar risk characteristics (such as similar market capitalization and volatility). The new investment is chosen in an effort to keep the portfolio’s overall allocation and risk exposures on track during the 30-day wash-sale period.
Once the 30-day window has passed, managers can potentially swap back into the original investment, or leave the new investment in the portfolio. If the market keeps declining, managers can continue to swap investments periodically, to potentially capture additional tax assets. (Note that repurchasing the original investment at a lower price will also lower the investor’s cost basis in the position. Because of this, the investor may face a higher tax bill if or when they sell the position than they otherwise would have.)