Tax: A Nice Problem to Have (and Some Partial Solutions) by Paul Robertson, AllianceBernstein
Paul Robertson and Tara Thompson Popernik
Many taxable US investors will face higher capital gains tax bills for 2014 than for 2013, although market returns are likely to be more modest. The reason isn’t higher tax rates: US tax rates were up in 2013, too. The reason is large capital gains and limited losses.
That’s a change. For several years, investors have enjoyed large capital gains while paying relatively low taxes on them. Global stocks returned over 160% and the S&P 500 returned nearly 200% from March 2009 through August 2014—but many investors were able to avoid paying much tax on gains through 2012 because they had net losses from 2008 they could apply to offset the gains.
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By 2013, many investors had exhausted their net tax losses from 2008, but rising yields that year created new losses in bonds. Many investors who didn’t have net losses on their overall portfolios sold bonds to harvest losses. That allowed them to defer paying tax on gains they realized on stock sales.
But all major asset classes are up year to date in 2014. And while the S&P 500 is up only about 8% (versus 32% in all of 2013), the stock market rally is remarkably broad. Only about 130 of the stocks in the S&P 500 were down as of the end of August, and only 18 were down more than 15%. That severely limits the opportunity to harvest losses this year.
Investors who sold off a cross-section of their stock holdings early this year to rebalance their portfolios after last year’s market run-up may not be able to put off paying tax on realized capital gains. The same is true for investors who sold highly appreciated securities to reinvest in securities with greater potential returns going forward.
How Loss Harvesting Works
The Display below shows that to offset a gain booked on Security A, an investor can sell Security B, which has fallen below its purchase price (or cost basis). The proceeds from the sale of Security B must be reinvested for the portfolio to stay fully invested, but Security B itself can only be bought back after 31 days to avoid violating the wash sale rules and thus losing the tax benefit of the trade.
Many investors believe that loss harvesting eliminates, or avoids, a capital gains tax liability. They are wrong. Almost always, loss harvesting merely defers a tax liability into the future. Essentially, loss harvesting reduces the cost basis of the portfolio, making future gains that much larger.
Deferring taxes allows a portfolio to grow a bit more. For an investor with a combined federal and state capital gains tax rate of 25%, deferring a $50 gain from the sale of security A by also selling security B can defer a $12.50 tax bill to a future year. It can also keep that $12.50 at work in the portfolio. If the investor keeps the money in the portfolio for more than a year and earns 10% on it, he will have a $1.25 return. Of course, that return is taxable when the gain is realized (again, at 25%), so the after-tax return from the trade will be $0.94.
But to generate that $0.94 return, the investor has sold and bought stock worth $50—for a total trade value of $100. When the benefit is this small, transaction costs must be taken into account. Even if an investor does not pay trading commissions, there are costs related to the difference between the purchase and sale prices (bid-ask spreads), which may narrow the benefit. Bid-ask spreads of 25 cents on the purchase and the sale would have a total cost of 50 cents, reducing the benefit of the trade to $0.44.
After years of market gains, investors aren’t likely to have many holdings trading at half their purchase price. If an investor bought a security at $100 a share more than a year ago and sells it for $90, for a loss of $10, or 10%, he will only defer $7.50 in tax. If market returns are only 7.5%, the tax benefit will be less than 20 cents—less than the 50 cents in transaction costs.
It doesn’t make sense to engage in tax trading if it’s going to reduce your wealth. Small losses are not worth harvesting.
What can investors do?
Fortunately, there are other tax-related trading strategies that investors or their portfolio managers can follow to reduce this year’s tax bite. In our view, the most important are:
- Avoiding sales of appreciated securities held less than one year (unless you think the near-term outlook is dire). The short-term capital gains tax is significantly higher than the long-term capital gains tax, particularly for people in the highest tax brackets.
- Paying attention to tax lots. If you sell the shares of a given stock with the highest cost basis, you will minimize the taxable gain.
- Postponing investments in mutual funds that will make capital gains distributions between now and year-end, so you don’t pay taxes on realized gains you did not benefit from.
Lastly, it helps to keep your perspective. While paying tax isn’t fun, you only have this problem because you made a lot of money. It’s better to garner large investment returns and pay tax on them than to earn small returns. High capital gains and few losses: that’s a nice problem to have.
The views expressed herein do not constitute, and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.
Paul Robertson is a Senior Portfolio Manager and Tara Thompson Popernik is Director of Research in the Wealth Planning & Analysis Group, both at Bernstein Global Wealth Management, a unit of AllianceBernstein Holding LP (NYSE:AB).