However, there are serious research arguing that the tax loss harvesting is "undervalued", among which included Robert D. Arnott et al (2001) , the founder of the Research Affiliates LLC. In short, their simulations appear to show that tax management alone produces 50bps annual alpha for the past two decades, or an enviable cumulative alpha of 10%. They argue that most active manager does not manage to track the index in the long run, let alone beating it. Thus tax management is a hidden treasure.
My view is that Mr. Arnott is right in the long run, but only in the long run. To achieve this goal, it requires quite demanding quality of short run tax management over a long time horizon, a skill and a will that most non-institutional investors do have possess.
I. The source of Alpha from Tax Management: the W-W.
At the heart of the tax management lies the W-W: When and at What rate to pay tax [1].
Let me start with the obvious choice. There are two tax rate, 15% or 35%. Which rate will you prefer?
For most people, the answer is the lower one. This is in essence what tax loss harvesting buys you in the first place: we arbitrage short term gain to long term gain, effectively reduces tax rate and produces positive alpha for the portfolio.
Now consider the slightly complicated timing question. Consider two options:
Option 1, pay $100 tax today.
Option 2, defer the tax for 1 year, invest the money in the stock market [2] and pay the tax 1 year later.
Which one shall I choose?
Let me rephrase:
IRS is willing to lend me $100 free of interest for a year to invest in the market. Shall I take it?
Yes if I expect the market to go up, No if I expect the market to go down.
Conditioning on never paying short term capital gain tax, the essence of tax loss harvesting is a interest free loan from IRS. If one could make positive return on the investment, it makes sense to defer; otherwise, it is a money loser. Thus in the short run, unless one has perfect market timing skill, tax loss harvesting can be either a bless or a curse, depending on how market turns out to behave.. However, in the long run, since we expect a positive capital appreciation, tax management is expected to yield considerable positive alpha.
Knowing this too well, IRS sets out to sabotage your easy alpha generating strategy with the dreadful Wash Sales Rule.
II. How Bad is the Wash Sale Rule?
Say I buy stock A at $10. It tanks to $5 in a week. I decide to wait it out. But in the mean time, I want to register a capital loss so that I can use it to offset other gains [3]. I sell it at $5 and buy it back immediately.
IRS prohibits me from doing this by the Wash Sale Rule. It bans reopening a new position on identical or sufficient similar investment within 30 calendar days of covering a loss position.
Under this rule, I cannot register the $5 dollars as capital loss yet. It will carry over to the next trade as tax basis. Instead $5 of the purchase price, my tax basis for the new position is $10. If the stock rises back to $10, on the broker balance, I make $5 profit since my cost basis is $5 for the new position, while for tax purpose I make even because the tax basis is $10 for the new position. It should be noticed that loss does not DISAPPEAR if one fails to pass the wash sale rule, it is merely DEFERRED.
In contrast, profitable recognition is not hindered by the Wash Sale Rule. So I register a short term profit whenever I close a winning position.
By doing so, IRS forces me to recognize loss late and in the long run while register profit early and in the short run. In fact, IRS tries to nudge me to pay at a higher tax rate (for short term capital gain) and pay it early (tax credit generated by loss is deferred to later days).
It is clever, you have to give IRS that. But it is far from perfect.
III. How to Manage Capital Tax for Long Term Investment
Retirement saving are typical long term investment, which makes tax management a necessity.
For starters, full in IRA/Roth/401K as much as possible. They are tax free until withdraw.
Now for the taxable account, one should relentlessly pursue Fabianism[4], which means delay at all cost.
One way is to reduce trading frequency. Tax is not calculated unless a position is closed.
Other than avoiding active trading, which is not a good habit anyway, when a position is sufficient underwater, say 20%, close it and cool down for 30 days. Other than registering tax loss, it forces one to combat the behavior fallacy of not letting it go when in loss, thus save him/her from felling prey to the momentum trade on the wrong side.
IV. Simulation (Yet to Come)
V. Conclusion
Contrary to what many believed, tax loss harvesting does help to enhance portfolio return in the long run, thanks to the generosity of the interest free loan from IRS.
However, such alpha requires both uncompromising discipline and methodical infrastructure to implement the strategy. In reality, such inhumane work is best left to computer algorithm.
EndNote
[1] There are one fringe benefits of shrewd tax management. Each fiscal year, individual can offset other tax income with capital loss, up to $3,000.
[2] Throughout the article, I will assume reinvesting of the tax savings.
[3] Loss can be carried over multiple tax years.
[4] For the historical origin of this term, check it out here.
