AVP Wealth Portfolio Manager | Johnson Financial Group
As Assistant Vice President, Wealth Portfolio Manager, Kelsey works with clients to achieve their unique goals and objectives.
3 minute read time
Every year at my family’s Christmas party, we do a lighthearted white elephant gift exchange. The gifts are always a total mixed bag. Last year, the highly coveted items like restaurant gift cards and Yeti mugs got the most attention, while people who opened undesirable gifts like at-home COVID tests (!) traded up. Some people were happy about the gift they ended up keeping. Others were not so lucky.
Every December, our portfolios may receive a somewhat unwanted gift as well—capital gains distributions. One of the silver linings of this year has been tax-loss harvesting. Taxes can create a drag on performance, but tax-loss harvesting helps us to minimize that drag. We know it’s not about what you make, but what you keep in the end.
Tax costs to investors come in a few forms: investor activity from buying and selling certain strategies, underlying fund manager activity that generates capital gains distributions, and income through dividends. Taxes can eat away at realized investment gains, but strategic portfolio management can help to mitigate gains and even add “tax alpha,” which is not seen in traditional performance reporting.
Tax alpha is the result of maximizing after-tax returns by optimizing tax-saving strategies. This is done through asset location and tax-loss harvesting.
The accompanying chart shows a hypothetical million-dollar portfolio. We assume that the portfolio grows at 15% over 10 years. If you are a tax-exempt investor, then you end up with a portfolio around $4 million dollars.
However, for taxable portfolios, investors must pay taxes on capital gains and income. Assuming about a 2% tax cost, which is the 10-year annual average for U.S. large-cap mutual funds, investors will need to pay about $678,000 in taxes, reducing the ending portfolio value to $3.37 million. One way to decrease this tax drag and increase tax alpha in portfolios is through tax-loss harvesting. By strategically “taking,” or realizing, losses in a portfolio, clients can offset the gains that lead to the tax drag.
Within client portfolios, we can optimize asset location by using active management in tax-favored accounts and passive management vehicles in taxable accounts.
This year’s market volatility has provided abundant opportunity for tax-loss harvesting. Here’s how it works:
Why bother? Because distributions are common, and tax rates can be substantial.
Industry data indicates that 71% of U.S. active managers have paid capital gains in the last five years. For taxable investors, these distributions may be viewed as a double-edged sword. On one hand, distributions signal that the fund achieved and took profits; but on the other hand, taxable investors are required to pay taxes on those gains. At the highest tax brackets, investors pay 40.8% for short-term gains and 23.8% for long term gains.
Our JFG portfolio management team has been hard at work this year to minimize gains in client portfolios in a year where almost every asset class has experienced negative returns. The market volatility driven by inflation, rising rates, and geopolitical events has been one of the worst years for both stocks and bonds, but it has created opportunity to take losses now.
Our team has been working to harvest losses as we approach year-end as well as avoid the distribution date on some strategies. Clients may be able to use these losses to offset gains taken this year, offset income, or carry the loss forward into future years.
While we work to understand each client’s unique situation, it is also important that we coordinate with your CPA to understand your individual tax situation. As always, please reach out to your JFG team with any questions. We are happy to help.
On behalf of Johnson Financial Group, we wish you a happy holiday season.
This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security. Opinions expressed herein are as of the date of this report and do not necessarily represent the views of Johnson Financial Group and/or its affiliates. Johnson Financial Group and/or its affiliates may issue reports or have opinions that are inconsistent with this report. Johnson Financial Group and/or its affiliates do not warrant the accuracy or completeness of information contained herein. Such information is subject to change without notice and is not intended to influence your investment decisions. Johnson Financial Group and/or its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Certain investments, like real estate, equity investments and fixed income securities, carry a certain degree of risk and may not be suitable for all investors. An investor could lose all or a substantial amount of his or her investment. Johnson Financial Group is the parent company of Johnson Bank and Johnson Wealth Inc. NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE