Client Memo: What Is Tax-Loss Harvesting and How Does It Help?

 “It’s Not How Much You Make, It’s How Much You Keep.”
— Robert Kiyosaki (Rich Dad, Poor Dad author)

One issue we’ve encountered over the past few years of strong market returns is the accumulation of embedded unrealized gains in taxable accounts. Remember, each year, a taxable account incurs tax obligations, including ordinary income tax on any interest generated by bonds, ordinary income tax on any short-term realized gains, and long-term capital gains tax (15% or 20% for joint incomes exceeding $551,000) on gains from positions held for more than 365 days.

To optimize tax efficiency, we aim to minimize short-term capital gains and limit long-term capital gains where possible.

What Is Tax-Loss Harvesting?

Tax-loss harvesting is a powerful investment strategy designed to reduce tax liability and enhance after-tax returns. This technique involves selling investments that have declined in value to realize capital losses, which can then be used to offset capital gains and potentially reduce taxable income for the same year.

How Tax-Loss Harvesting Works

Let’s say a client purchased stock for $10,000, but its current market value has dropped to $6,000. By selling the stock, they realize a $4,000 capital loss. If the client also realized a $7,000 capital gain from another investment sold during the year, they can use the $4,000 loss to offset part of that gain.

• As a result, they would owe capital gains tax on only $3,000 instead of $7,000.
• If the capital gain is long-term, the tax liability would be $450 instead of $1,050 (assuming a 15% tax rate).
• The $600 tax savings can then be reinvested, compounding over time to enhance long-term returns.

Additional Benefits of Tax-Loss Harvesting

The advantages of tax-loss harvesting go beyond just offsetting capital gains:

✅ Offset Ordinary Income: If capital losses exceed capital gains in a given year, up to $3,000 ($1,500 for married individuals filing separately) can be used to offset ordinary income.

✅ Carry Forward Losses: Any excess losses beyond $3,000 can be carried forward indefinitely to offset future capital gains or ordinary income in later years.

✅ Maximize After-Tax Returns: By systematically harvesting losses, investors can reinvest in similar securities while keeping overall market exposure, making volatility work in their favor rather than against them.

Important Considerations: The Wash-Sale Rule

While tax-loss harvesting offers substantial benefits, it’s important to comply with the IRS Wash-Sale Rule. This rule prohibits investors from claiming a tax-deductible loss on a security if they repurchase the same or a “substantially identical” security within 30 days before or after the sale.

To maintain exposure while avoiding this rule, an investor can:
✔ Replace a sold stock with an ETF in the same sector (e.g., sell Apple, buy QQQ).
✔ Replace a sold ETF with a similar but different one (e.g., sell SPY, buy VOO).

How Noble Implements Tax-Loss Harvesting

At Noble, we harvest tax losses throughout the year—not just in December, as many advisors do. Our advanced portfolio management system enables us to identify tax-loss harvesting opportunities in real-time, allowing us to act when market conditions are most favorable.

Introducing Direct Indexing: A More Advanced Approach

A relatively new and increasingly popular strategy is direct indexing, which seeks to replicate a stock index, such as the S&P 500, in a taxable account.

Instead of investing in an index fund, direct indexing involves directly owning the individual stocks in the same proportions as the index. This approach allows investors to sell losing positions while letting winning positions run. After 30 days, to comply with the wash-sale rule, we can repurchase the sold securities or invest in similar ones to maintain exposure.

Why Direct Indexing Can Be a Game-Changer

The benefits of direct indexing compound over time:
📈 Tax Savings Reinvested: Harvested losses can generate annual tax savings, which, when reinvested, increase the portfolio’s long-term growth potential.
📈 More Tax-Efficient Than Traditional Funds: Unlike mutual funds or ETFs, direct indexing allows for better control over tax liability, reducing unnecessary capital gains distributions.

Looking Ahead

We will be implementing direct indexing in select client accounts in the near future to capitalize on these opportunities. As always, we are committed to optimizing your investment strategy while ensuring the highest level of tax efficiency.

We greatly appreciate the trust you place in us and look forward to helping you achieve your financial goals.

Sincerely, 

Mark J. Asaro, CFA