Why it's the perfect time — and potentially the worst — for tax-loss harvesting

The best time to minimize taxes on investments can also be the most treacherous.

The danger, resurgent as markets gyrate following a horrible 2022 for Wall Street, lurks within a tax strategy that's increasingly popular with financial advisors seeking to eke out a sliver of extra return for their clients, especially affluent ones.

The technique works like this: An advisor sells a client's stocks, bonds or funds whose value has declined, then uses the losses to offset the tax bills that arise when gains are taken on profitable investments or owed on ordinary income, such as salaries.

Tax-loss harvesting, as it's known, has two best friends: temporarily volatile markets that bring winners and losers to the fore, if only for the moment, and prolonged bear markets. Both have been on display since early 2022, when the longest-running bull market in history began to peter out; while the S&P 500 has rallied roughly 10% so far in 2023, it has been on a rollercoaster amid a spate of jarring economic news.

"In these volatile periods, there is more opportunity for harvesting," said Jeremy Milleson, a director of investment strategies at Parametric Portfolio Associates in Seattle. At the same time, he added, "you need to be very careful."

Jolts
So far this year, Wall Street has been been whipsawed by Federal Reserve deliberations about further interest rate hikes, a banking crisis in March, a nail-biter showdown in Congress over a potential U.S. debt default and weak earnings from household-name companies like Home Depot and Target, where consumers are pulling back on spending as the economy faces a recession.

On the surface, the jarring news makes for an ideal time to pounce on losing stocks and intentionally sell them to generate valuable losses. But doing so can bite you back.

"Tax-loss harvesting beaten-down stocks during a market crash can lead to underperformance when the market recovers and stocks bounce back," said a research paper from three Parametric employees that was published in the Journal of Beta Investment Strategies last June. The wealth management firm is an early pioneer of the strategy. 

Read more: Selling losing stocks for a tax boost? A new paper says beware these tripwires

Specifically, Milleson said, a stock that's losing value at a given moment can be the quickest to rebound. And if you've intentionally sold that lagging share to reap the tax value of its loss, you and your portfolio can miss out on the subsequent bounce back.

"We've observed some behavior around loss harvesting that's disconcerting — and potentially damaging to the long-term health of investors' portfolios," Milleson wrote in a May 15 blog post.

Silver lining's rough edge
The danger of missing a rebound is often overlooked as wealth management firms increasingly embrace the strategy. Why? Because the main tripwire with the technique is usually pegged to something entirely different. 

Specifically, the Internal Revenue Service's wash-sale rule, aimed at preventing gaming the system for deductions. The rule says that an investor can't sell a stock, bond or mutual fund at a loss and then repurchase it, or a "substantially identical" asset, within 30 days before or after the sale. Make a timing or security selection mistake, as investors or advisors can do, and the deduction disappears.

In any market slump, losses can be a silver lining. That's because the Internal Revenue Code says that once an investor sells shares that have declined in value, the losses can offset the taxes owed on gains taken from cashing in winning investments, dollar for dollar. 

There's another benefit: If the losses exceed gains taken by selling other, appreciated securities, the investor can deduct up to $3,000 of them each year against her taxable income. A third perk: Any unused losses can be carried forward to offset subsequent taxable gains in future years (New Jersey doesn't allow that for state tax purposes).

Kevin Brady, a certified financial planner and vice president at Wealthspire Advisors in New York, called the strategy "particularly valuable for clients who will perpetually remain in a high bracket or are planning to sell a primary/second residence." He said he's using the technique on value and dividend-paying stocks that have faltered as growth stocks perform well so far this year. 

'Is this legit?'
Tax-loss harvesting is perfectly legal, despite some investors who mistakenly think it's not.

Andrew Kunzweiler, a portfolio manager at Morningstar Investment Management, a registered investment advisor that's part of Chicago-based investment research firm Morningstar, said some investors ask if the technique "is some sort of tax evasion scheme." Of course, it's perfectly legal. 

"The key thing to know is that it allows you to keep money that otherwise would have been sent out to the IRS in taxes invested in the portfolio, earning the market return and compounding over time," Kunzweiler said.

The strategy is also a valuable tool for financial advisors. In a May 4 research note, Kunzweiler wrote that "market uncertainty can kick-start important conversations and unearth potential opportunities — giving advisors more ways to demonstrate their value." Volatile markets, he wrote, "provide fertile ground for this strategy" and advisors "can help their clients realize losses as they become available in their portfolios — with daily reviews."

Investing trends collide
Tax-loss harvesting is a prominent feature of direct indexing, another investing trend in which investors follow custom benchmarks with a built-in return. Typically used by affluent clients but recently more available to mainstream savers through Fidelity Investments and Charles Schwab, the niche approach involves creating or following a bespoke benchmark of hand-picked securities that sync up with an investor's personal values or investing philosophies. 

Direct indexing, into which investors had poured $362 billion as of 2020, will grow more than 12% over the next five years, outpacing traditional products such as mutual funds, exchange-traded funds (ETFs) and separate investment accounts, a 2021 Cerulli Associates report found. 

Read more: Who benefits from direct indexing's tax bounty? Probably not you

Despite the appeal of "all about me" investing, direct indexing may amplify the dangers of tax-loss harvesting by causing a portfolio to stray from its benchmark when losses are booked. That's because harvesting losses can skew a benchmark's overall returns — a condition known as tracking error — and set into motion a painful portfolio rebalancing aimed at remedying things.

"You have to make sure from a risk perspective that you're still going to get the correct exposure," Parametrics' Milleson said.

Tax oops
In essence, tax-loss harvesting can trigger market timing, a typically self-sabotaging exercise in which an investor thinks he knows better than the pros and sells or buys based upon an immediate data point or panics about performance.

For example, take an investor (or advisor) who freaked out and thought it was a good idea to sell Tesla shares last Jan. 3, when they traded at just over $108. Thirty calendar days later on Feb. 2 — the earliest the investor could buy back the stock and avoid triggering the wash-sale rule — Tesla hit more than $188. The gambler missed out on a 74% increase in the space of a month.

Parametric's Milleson said that household stocks in a slump at any given moment are often the ones to bounce back the soonest. So dumping them for their tax losses can be counterproductive. Stocks like Tesla, he said, "typically outperform or do the best when the market recovers."

Read more: The risky side of tax-loss harvesting that advisors need to know

"Missing a handful of the best days in the market over long time periods can drastically reduce the average annual return an investor could gain just by holding on to their equity investments during sell-offs," Wells Fargo Investment Institute wrote last September. "While missing the worst days can potentially offer higher returns than a buy and hold strategy, disentangling the best and worst days can be difficult, since historically they have often occurred in a very tight time frame — sometimes even on consecutive trading days."

One guardrail against missing out on a quick rebound, he added, is to intentionally sell only some, not all, of a given company's or fund's shares.

Joel Mittelman, a financial planner and chartered financial analyst who is the president and chief investment officer of Mittelman Wealth Management, a family office firm in Andover, Massachusetts, said that "If anything, during macro driven market volatility, one should look for acute weakness as a potential opportunity to add to a high-conviction idea."