Financial Planning Perspectives—Your mileage may vary: Setting realistic tax-loss harvesting expectations

Financial Planning Perspectives

Your mileage may vary:

Setting realistic tax-loss

harvesting expectations

In recent years, tax-loss harvesting (TLH) has been aggressively advertised as a near-certain way to

increase after-tax returns by anywhere from 100 basis points to 200 basis points—in some cases even

300!—annually. (A basis point is one-hundredth of a percentage point.) As a result, many investors and

advisors consider TLH to be one of the few “free lunches” that remain in investing. We do not disagree with

this assessment for the “right” investors—those (usually very wealthy) investors who have frequent and

sizable capital gains (often generated from taxable investments held in active or nonpublic equities). But

many individual investors do not fit this mold or should first focus on other more valuable options such as

investing in tax-advantaged accounts. These investors will eventually be disappointed with the size of their

TLH benefit if they set their expectation at 100 to 200 basis points.

In this paper, we explore the potential of tax-loss harvesting for all investors. Much of the success in

TLH comes from knowing how it works and what drives the outcomes, which we cover first. We then

bring this understanding to bear on how to customize a TLH strategy so investors get the most from their

tax-loss harvesting experience. After all, there is a role for TLH in most affluent investors’ portfolios. The

key question is how big this role can be. We explore this question in a case study that illustrates how the

benefit from a TLH strategy can vary greatly from individual to individual.

n How tax-loss harvesting works

The two main sources of value from

TLH are 1) the potential to lower

overall taxes by deferring a tax liability

to a point in the future when the

investor is subject to lower tax rates;

and 2) the ability to invest today’s tax

savings for further capital growth into

the future.

n Why outcomes can vary

The value from TLH varies

considerably across market

environments, investment

horizons, cash contribution

profiles, and investor tax situations.

We show when and for whom

TLH may be most valuable as an

enhancement to current wealth

management strategies.

n When to implement TLH

Using a case study, we discuss

the relevance of TLH for everyday

investors based on their goals and

savings capacity. The potential benefit

depends on the investor’s tax profile

and level of offsettable income.

Figure 1. TLH adds value through tax rate substitution and increased market exposure

Portfolio with

tax loss harvesting

Initial balance

Portfolio

without

TLH

Portfolio

with TLH

$30,000

Capital loss: 10%

$27,000

Tax-loss

harvesting

Harvest $3,000 by selling the original

investment and purchasing a nonsubstantially

identical replacement security.

Offset $3,000 of ordinary income, resulting

in a $900 tax savings that is reinvested.

This process pushes down cost basis,

embedding a future tax liabililty into

the portfolio.

$900

Market gain: 100% After-tax balance

End of rst yearCurrent year

$54,000

$55,800

$49,200

$50,220

$24,000 capital gain

Liquidation of position

$27,900 capital gain

$1,020

benet

from TLH

$300

$720

result of

tax savings

investment

result of

tax rate

substitution

Source: Vanguard.

How tax-loss harvesting works

TLH is a strategy for boosting after-tax returns in taxable accounts. Generally, investors

pursue TLH with their equity holdings in taxable accounts because equities’ high volatility

creates opportunities to sell these securities at a loss. Under federal tax law, U.S.

investors can use harvested losses—investments sold at a loss relative to the cost

basis—to offset realized capital gains and up to $3,000 of ordinary income each year to

reduce their tax bill. This helps the investor in two main ways: tax rate substitution and

growth of invested tax savings.

Tax rate substitution refers to the tax savings an investor generates by shifting a tax liability

from today to sometime in the future with a (hopefully) lower tax rate. By investing the tax

savings generated today, investors can add capital growth with their deferral of taxes. (We

can also think of it as investing an interest-free loan from the IRS in the stock market.)

Let us show how this works in practice with a simple example in Figure 1.

In the first case (Portfolio without TLH), a $30,000 investment grows to $54,000 over

several years with no intervening transactions, and is liquidated for an after-tax value of

$49,200 (we assume a long-term capital gains tax rate of 20%: $54,000 – 20% capital

gains tax x $24,000 capital gain).

U.S. investors can

use harvested

losses to reduce

their tax bill.

Figure 2. Core drivers of TLH benefit

Less

TLH

potential

TLH

potential

Higher

Less

Lower

Few broad-based funds

Lower

Higher

Many individual securities

Higher

Liquidation level

Invested cash ows

Offsettable income

Volatility

Portfolio construction

Tax rate spread (harvest—liquidation)

Source: Vanguard.

The value of

TLH is a function

of timing and the

amount of tax

savings an investor

can generate.

In the second case (Portfolio with TLH), we see the effects of tax-loss harvesting. At first,

the original $30,000 position decreases in value to $27,000. If the investor sells and reinvests

this position, the $3,000 loss can offset an equivalent amount of gains or income and

associated taxes due that year. We assume that this investor is subject to 30% income taxes

and is able to reduce taxes by $900 with a $3,000 harvest. After reinvesting this $900 of tax

savings, the resulting $27,900 grows to a final value of $55,800, or $50,220 once liquidated

($55,800 – 20% capital gains tax rate x $27,900 capital gain). Through this process, this

investor increased the after-tax return by $1,020. Three hundred dollars of the $1,020 was

the result of tax rate substitution: This investor was able to substitute paying a 30% income

tax at the end of the first year with paying a 20% long term-capital gains tax at liquidation

($3,000 x (30% income tax – 20% capital gains tax)). The remaining $720 is from the growth

of the invested tax savings: By increasing the amount invested in the market by $900 early

on, the investor achieved extra growth ($900 x 100% return x (1 – 20% capital gains tax)).

Why outcomes can vary

As we show in the example above, the value of TLH is a function of the timing and amount

of tax savings that an investor can generate by harvesting losses. (Please see “The tax-loss

harvester’s how-to guide” on page 6.) Historically, TLH outcomes have varied significantly

from investor to investor based on their market environment, investment profile, and

personal tax situation. In Tax-Loss Harvesting: A Portfolio and Wealth Planning Perspective

(Khang, Paradise, and Dickson, 2020), we identified primary drivers of the efficacy of TLH.

We show how these key drivers affect TLH outcomes in Figure 2.

4 1 U.S. marginal tax rates are set to increase on December 31, 2025.

Volatility

The greater the volatility in the market, especially shortly after an investment is made,

the greater the opportunity to harvest losses. This typically leads to a greater TLH benefit,

as long as the market rebounds after the high-volatility period. From this standpoint, the

2000s and 2010s represented ideal conditions for tax-loss harvesting. There were two

highly concentrated harvesting opportunities in the form of the dot-com bust of the early

2000s and the global financial crisis of 2008; both were followed by extended periods of

strong market growth. If more stable markets prevail in the future, as they did in the

1980s and 1990s, we may not see the same potential for TLH benefit.

Number of portfolio securities

Unfortunately, the market environment that awaits investors is entirely out of their

control. That said, one lever TLH investors do have is the number of portfolio securities.

Holding individual securities instead of pooled-investment funds enables investors to

capture losses even in bull markets with low volatility. This ability to generate losses even

in an overall low-volatility environment is an attractive feature for TLH-minded investors

with excess capital gains.

Tax situation

The higher today’s tax rate is relative to the future tax rate, the greater the benefit from

tax rate substitution. But some investors may not benefit much from TLH because their

tax rates today are already low relative to their likely future rates. Two examples are those

just starting out in their accumulation phase who expect higher levels of income in the

future and those who experience a dramatic increase in marginal tax rate (especially on

long-term capital gains) in the future because of legislative changes.

Offsettable income

For many diligent tax-loss harvesters, the limiting factor in achieving a greater TLH benefit

may not be the lack of losses. Instead, it is the lack of income (capital gains and up to

$3,000 of income) to consume the losses. This income determines how much of the loss

harvests eventually turn into tax savings and reinvestment. Without capital gains, TLH is

less valuable, because all it can do is reduce taxable income by, at most, $3,000 every

year. While this $3,000 can be a significant portion of the portfolio for lower taxable

balances, it can become trivial for larger account balances.

This is why we believe the nature and (eventual) size of capital gains are central to a smart

use of TLH for many mass affluent and high-net-worth investors. For advisors and investors

alike, it is mission-critical to understand whether you can expect capital gains of material

magnitude from other parts of the portfolio. If you have significant investments in real estate

or private equity, or you own a business, you are likely a prime candidate for tax-loss

harvesting. If your portfolio largely holds liquid publicly traded securities, which tend to be

more tax-efficient, you are likely to benefit far less from TLH.

Cash flows

Good investment behavior can often complement TLH. Investors who regularly save and

contribute to their portfolio, creating more frequent and larger cash flows, will diversify

the cost bases of their tax lots (shares of a security that are purchased in a single

transaction), creating more harvesting opportunities in volatile markets. In addition,

investors who integrate TLH with their rebalancing process, using harvest proceeds to

rebalance their portfolios, will have lower transaction costs than they would if they had

kept these processes separate.

Poor for TLH

Median: 0.0%

Bottom 25th percentile

Middling for TLH

Median: 0.25%

50th to 75th percentile

Ideal for TLH

Median: 1.36%

Top 25th percentile

Volatility

Lower Higher

Portfolio

construction

Broad-based funds Individual securities

Tax rate spread

(harvest—liquidation)

Lower Higher

Offsettable income

Less More

Invested cash ows

Less More

Liquidation level

Higher Lower

Liquidation level

TLH can also be a complementary strategy for those planning to make charitable

contributions during their lifetime or bequeath a portion of the portfolio to heirs. In

these cases, TLH can permanently reduce taxes in both the short and the long term

as depressed cost bases receive a step-up. (Cost bases are reset to their price level at

the time that assets are passed as a bequest, eliminating the built-in capital gains.)

Putting it all together

How do these drivers affect the TLH outcome? To show the drivers at work, we simulated

thousands of TLH scenarios, varying the core drivers over 15-year periods during 1982

through 2017. We organized the empirical outcomes into three groups, represented in

Figure 3.

The first (orange) represents scenarios where all drivers are in the bottom 25%

of what we would consider ideal for TLH—in other words, low volatility, low tax rate spread,

low offsettable income, low cash flows, and a high liquidation (selling assets during the

investor’s lifetime rather than passing them on to heirs or charities). In the next group (blue),

we consider instances where all drivers are in the 50th to 75th percentile. The final group

(green) represents scenarios where all drivers are in the top 25%. From Figure 3 below,

we can see that the median benefits of these groups were 0, 25, and 136 basis points,

respectively, though each group showed diverse results. For a sizable TLH benefit, it is

important that all (or most) drivers are working together; missing out on a few of the drivers

may leave investors with little to no TLH benefit even if the other conditions are ideal.

Last, but not least, if you are an investor considering TLH for your portfolio, we recommend

that you first maximize investing in tax-advantaged accounts even if it leaves a smaller

taxable portfolio for TLH opportunities. It is true that TLH will likely generate a positive benefit

(though with widely varying range) for many individual investors. That said, for investors who

save primarily for retirement, TLH should not come at the expense of using tax-advantaged

accounts. As Paradise and Kahler (2020) show, investing in tax-advantaged accounts is likely

to add more value than anticipated by even our highest TLH projections.

Figure 3. Relationship of key drivers with TLH benefit

Notes: Empirical data include TLH simulations over eight overlapping equally spaced 15-year periods from 1982 through 2017. The 25th, 50th, and 75th percentiles of volatility

correspond to 14%, 15%, and 17% annualized, respectively; –16%, 0%, and 16% for tax rate spread; 1%, 2.5%, and 4% of taxable equity balance for offsettable income

availability; 2%, 5%, and 8% of initial portfolio balance for cash flows invested quarterly; and 20%, 50%, and 80% for liquidation at the end of the 15-year period.

Source: Vanguard calculations using data from Axioma.

2 We refer interested readers to our companion paper Khang, Paradise, and Dickson (2020) for details on this analysis and how we model and create predictive

distributions of TLH benefits for the future, incorporating all key drivers.

The tax-loss harvester’s how-to guide

When to harvest

It can be challenging to determine when to begin the tax-

loss harvesting process, when to sell, and for how much

of a loss. Losses can be ephemeral, often quickly erased,

because of volatility. When abundant losses are available,

an investor should take advantage of them by selling the

investments because the losses can be carried forward

indefinitely to offset income and capital gains. At the

same time, whenever an investor harvests a loss, tracking

error relative to the originally planned portfolio increases

because of the wash sale rule. (This rule prevents an

investor from repurchasing a “substantially identical”

security within 30 days of the sale. More on this below.)

Ideally, an investor strikes the right balance: capturing

losses while they last but not acting too quickly and

missing out on further depreciation.

It seems that rules-based harvesting (e.g., harvesting a

loss in excess of a threshold) can generally deliver a set

of similar results so long as the harvesting threshold is

not too ambitious—generally, anything below 10% yields

similar results. On the margin, investors may also be able

to harvest more by screening for losses on a daily basis

rather than a monthly or quarterly basis. Figure 4 shows

that by checking for losses on a daily basis, the resulting

TLH benefit would have been about 6 and 18 basis points

greater than with monthly and quarterly screening.

One last pitfall to be aware of when timing harvests is

that gains are taxed within calendar years. This argues

for booking sound losses in advance. If a loss is harvested

after year end or washed through a premature purchase

of the same security sold for a loss, the gains that

otherwise could have been offset in the calendar year

are an opportunity lost forever.

What to harvest

It is also important to consider which tax lots to sell

when harvesting losses. The ideal situation is to sell lots

that generate the greatest loss per dollar of proceeds

from the sale.

In order to do this, investors should select

the specific tax lots of a given security with the highest

cost basis (this is called highest-in-first-out accounting,

a.k.a. “HIFO”). Dickson, Shoven, and Sialm (2000) and

others have shown that TLH with HIFO generally

increases after-tax returns of by approximately 5 to 9

basis points a month depending on net cash flows.

Navigating the wash sale rule

After harvesting a loss, investors typically purchase

a similar investment to maintain consistent portfolio

performance. When replacing the position, an investor

must be mindful not to violate the IRS wash sale rule.

This rule prohibits taking a tax loss if a substantially

identical security is purchased 30 days before or after

the loss transaction. If the transaction violates this

provision, the capital loss is disallowed and is added

to the cost basis of the newly purchased security.

Unfortunately, the IRS has provided limited guidance on

what constitutes “substantially identical.” The goal is to

select a replacement that you expect to perform similarly

enough that you do not introduce excessive tracking error

into your portfolio, but that is different enough that you

do not run afoul of the wash sale rule.

Figure 4. TLH benefit by harvesting frequency

Average TLH benet

0.00

0.10

0.20

0.30

0.40%

Daily

Monthly Quarterly Annually

Notes: Figure 4 depicts the average TLH benefit for 15-year rolling periods, from the

period starting in 1982 to the period starting in 2005 and concluding in 2019. The

frequency indicates how often the portfolio was scanned for harvesting opportunities,

which were identified as tax lots with at least a 10% loss relative to cost basis. This

analysis assumed quarterly cash flows of 5%, capital gains availability of 3% of the

portfolio value, an eventual liquidation of 50%, a harvest tax rate of 40%, a liquidation

tax rate of 25%, fund-level harvesting, and a relative transaction cost of 10 basis points.

Source: Vanguard calculations using data from Axioma.

3 In extreme cases, excessive trading of a security can create large amounts of realized capital gains and unrealized losses. If the continual sale and repurchase of the

security washes those losses so that they continue to be unrealized beyond year end, the gains will be taxable and the investor will be unable to retroactively offset them.

For a further examination of this issue, see Macqueen (2021).

4 One twist to this strategy is to separate harvestable tax lots into two groups—short-term losses and long-term losses—and to sell lots in this order. This strategy

prioritizes the harvesting of short-term losses, as they are subject to income tax rates. If both short-term and long-term gains exist, losses of the same category are used

first to offset like gains (i.e., short-term losses against short-term gains), making short-term losses potentially more valuable than long-term losses.

5 The holding period of the new security is also adjusted to include the holding period of lots that were sold to create the capital loss. For securities that are repurchased in a

retirement account, losses are permanently disallowed and the basis of the replacement security is not adjusted. See IRS Revenue Ruling 2008-5 for additional information.

Case study: When to implement TLH

Armed with these lessons and guidelines,

when should one put TLH into practice?

We use the example of two hypothetical

investors—Robin and Bruce—to show how

to make an appropriate use of TLH, paying

attention to differing opportunity costs and

capital gains profiles.

Robin is a doctor in her early 30s and is saving primarily

for retirement. She is currently in the 22% income tax

bracket. But after she finishes her residency in two years,

she expects to spend most of her career in the 32%

bracket or (ideally) a higher bracket. Robin prioritizes

saving in her 401(k) retirement account and her 529

educational savings account. The modest balance in her

taxable brokerage account is invested in passive index

funds, so she doesn’t expect to generate significant

capital gains in the near future. Given her expectations

for a rising tax rate and low expectations for capital gains,

Robin is unlikely to benefit much from TLH. In fact, by

potentially deferring taxes to a time when she is in a

higher income tax bracket, she may end up subtracting

value if she harvests losses today.

Bruce, on the other hand, is in his late 50s. He is a

partner at a large consulting firm that is still growing at

a healthy pace; he regularly realizes capital gains when

new partners buy into the partnership every few years.

He is currently in the 35% bracket, but, based on his

plans for a frugal retirement lifestyle, he aims to be in

the 24% income tax bracket throughout retirement. In

addition, he is planning to sell his partnership interest in

the next seven years and expects the sale to generate

capital gains of around $4 million. Given Bruce’s shrinking

tax rate expectations and sizable capital gains projections,

he is a prime candidate for TLH.

What are Robin’s and Bruce’s TLH benefit expectations?

Given these two profiles (and using the same framework

we used for distributions in Khang, Paradise, and Dickson,

2020), we can predict Robin’s and Bruce’s expected TLH

benefit distributions. As anticipated, Robin’s expected

benefit is just as likely to be negative as positive. But

Bruce, with his favorable tax rate spread and the very

large capital gains he expects in the near future, is

estimated to receive a much greater annualized TLH

benefit of 47 basis points. Based on this, there may not

be a strong case for Robin to tax-loss harvest, relative to

other tax-advantaged opportunities that still may be

available to her. Bruce, on the other hand, is much more

likely to benefit from proactive TLH.

Figure 5. Personalized projections of TLH benefit

TLH benet differential

–1.00

0.00

0.50

1.00

1.50%

–0.50

Robin

– 0.18%

0.73%

–0.73%

0.18%

0.00%

Bruce

0.29%

1.20%

–0.26%

0.65%

0.47%

1st

99th

Percentiles

key:

75th

25th

Median

Notes: These projections are made considering a 15-year period. The inputs for creating Robin’s projected distribution are 22%, 32%, 1%, 5%, and 75% for harvest tax rate,

liquidation tax rate, capital gains, cash flows, and liquidation amount, respectively. The inputs for Bruce’s projected distribution are 35%, 24%, 6%, 5%, and 25%.

Source: Vanguard.

Conclusion

When it comes to tax-loss harvesting, one size does not fit all. Investors who expect

to have lower future tax rates and have significant losses, which they can use to offset

significant capital gains, should expect to benefit from TLH. Those who are fortunate

enough to also benefit from strong market performance after their harvests will likely

benefit even more.

For investors who don’t fit this description or who have yet to contribute the maximum

amount to their tax-advantaged accounts, TLH might not move the needle. By understanding

their personal potential, individual investors working with their advisors can develop a TLH

strategy best suited for them, without introducing uncompensated risks or operations into

their portfolio.

References

Dickson, Joel M., John B. Shoven, and Clemens Sialm, 2000. Tax Externalities of Equity Mutual

Funds. National Tax Journal 53(3): 607–628.

Khang, Kevin, Thomas Paradise, and Joel M. Dickson, 2020. Tax-Loss Harvesting: A Portfolio and

Wealth Planning Perspective. Valley Forge, Pa.: The Vanguard Group.

Paradise, Thomas, and Jonathan R. Kahler, 2020. What to Do With Your Next Dollar: A Quantitative

Framework. Valley Forge, Pa.: The Vanguard Group.

Macqueen, Alexandra, 2021. Can You Owe $800k Tax on a Profit of $45k? Morningstar, Inc., March

26; available at https://www.morningstar.ca/ca/news/210709/can-you-owe-$800k-tax-on-a-profit-of-

$45k.aspx.

In tax-loss

harvesting,

one size does

not fit all.

ISGTLHE072021

Connect with Vanguard

> vanguard.com

Vanguard research authors

Thomas Paradise

Kevin Khang, Ph.D.

Joel M. Dickson, Ph.D.

All investing is subject to risk, including the possible loss of the money you invest. We

recommend that you consult a tax or financial advisor about your individual situation.