Taxes | March 13, 2020

How Tax-Loss Harvesting Can Help Take Advantage of Volatility

When market volatility inevitably ramps up from time to time, riding that roller coaster can sometimes leave you feeling a bit queasy. But that doesn't mean the only thing you can do is close your eyes and hang on until the ride ends. For savvy investors, volatility can actually provide opportunities for agile trading that can be used to their advantage.

For instance, tax-loss harvesting is a powerful tool that may help reduce current tax liabilities for taxable accounts and potentially leave you more to invest over time, but it's a complicated and time-consuming process for individual investors to manage. For many years, this type of sophisticated service was only available to the wealthiest investors. But now, Schwab Intelligent Portfolios® is able to use the power of technology to automate this complex process for you. For a more in-depth look at how tax-loss harvesting works, the tax implications and the IRS "wash sale" rule, please visit this white paper.

Tax-loss harvesting trades increased during market volatility

While tax-loss harvesting trades have occurred every month since the March 2015 launch of Schwab Intelligent Portfolios, periods of elevated market volatility highlight the potential benefit of the tax-loss harvesting feature. The number of tax-loss harvesting trades across Schwab Intelligent Portfolios accounts that are enrolled in the service have historically surged when markets turn turbulent.

The market correction during Q4 2018 and subsequent rebound in Q1 2019 help illustrate the power of tax-loss harvesting. As Figure 1 shows, the total number of tax-loss harvesting trades across Schwab Intelligent Portfolios rose sharply along with market volatility in Q4 2018 as the U.S. stock market tumbled. Clients enrolled in tax-loss harvesting were able to capture the losses for tax purposes by selling the ETFs in their portfolio that had declined enough below their purchase price. Additionally, because the tax-loss harvesting feature simultaneously reinvests the proceeds of the sale into an alternate ETF in the same asset class to keep clients invested according to their targeted asset allocation, those clients stayed invested and benefited from the market rebound in Q1 2019.

Figure 1: Tax-loss harvesting trades have increased when markets turned turbulent

tax-loss harvesting chart

Charles Schwab Investment Advisory and Morningstar Direct, 7/1/2018 – 6/30/2019

A tax-loss harvesting case study

To further illustrate how tax-loss harvesting works, we examined the tax-loss harvesting trades that occurred in a Schwab Intelligent Portfolios account that most closely mirrors the model portfolio during December 2018, the most turbulent month during the Q4 volatility. The representative account had a balance of approximately $100,000 and was invested in a globally diversified total return strategy based on a moderate growth risk profile consisting of 61% stocks, 26.5% fixed income, 2% commodities and 10.5% cash.

As shown in Figure 2, the account saw 11 tax-loss harvesting trades in December 2018. Total losses harvested during the month came to approximately $3,608. While not listed in this example, the account experienced tax-loss harvesting trades in other months of the year as well. These captured losses accrue over the course of the year and may potentially be used to help offset realized capital gains when filing year-end tax returns and up to $3,000 in ordinary income to the extent that captured losses exceed an investor’s capital gains for the year.

While tax-loss harvesting does not eliminate tax liabilities (future taxes would need to be paid based on the cost basis of the replacement security whenever it is sold at a later date), it defers taxes and can help to potentially reduce current tax liabilities.

This is just an example for illustrative purposes, and the tax-loss harvesting activity within your account depends on market conditions, when you opened your account, subsequent deposits/withdrawals, whether you switched to a different portfolio after opening the account, and other factors.

Figure 2: Tax-loss harvesting trades have increased when markets turned turbulent

Schwab Intelligent Portfolios includes primary and secondary ETFs in each asset class in order to be able to capture losses when the market presents these opportunities while also maintaining your strategic allocation by reinvesting into the alternate ETF in that asset class.

 
Date Asset class Tax-loss harvesting activity Harvested loss*
12/6/2018 International Developed Markets Large Company Stocks – Fundamental
  • Shares of primary ETF (FNDF) sold
  • Shares of secondary ETF (PXF) bought
$331.21
12/14/2018 U.S. Small Company Stocks
  • Shares of primary ETF (SCHA) sold
  • Shares of secondary ETF (VB) bought
$320.81
12/14/2018 International Developed Markets Small Cap Stocks – Fundamental
  • Shares of primary ETF (FNDC) sold
  • Shares of secondary ETF (PDN) bought
$270.00
12/17/2018 U.S. Large Company Stocks
  • Shares of primary ETF (SCHX) sold
  • Shares of secondary ETF (VOO) bought
$318.75
12/17/2018 U.S. Large Company Stocks – Fundamental
  • Shares of secondary ETF (PRF) sold**
  • Shares of primary ETF (FNDX) bought
$279.36
12/21/2018 International Developed Markets Small Company Stocks
  • Shares of secondary ETF (VSS) sold**
  • Shares of primary ETF (SCHC) bought
$266.99
12/21/2018 U.S. Small Company Stocks – Fundamental
  • Shares of secondary ETF (PRFZ) sold**
  • Shares of primary ETF (FNDA) bought
$771.14
12/21/2018 High-Yield Bonds
  • Shares of primary ETF (HYLB) sold
  • Shares of secondary ETF (USHY) bought
$269.07
12/24/2018 U.S. Real Estate Investment Trusts (REITs)
  • Shares of primary ETF (SCHH) sold
  • Shares of secondary ETF (USRT) bought
$354.29
12/26/2018 Emerging Markets Stocks – Fundamental
  • Shares of secondary ETF (PXH) sold**
  • Shares of primary ETF (FNDE) bought
$202.02
12/26/2018 Emerging Markets Stocks
  • Shares of secondary ETF (IEMG) sold**
  • Shares of primary ETF (SCHE) bought
$223.66
Total     $3,607.93

This example should be interpreted as illustrative only and not representative of an actual client's experience.

*Harvested losses take into account the purchase price (cost basis) of the security sold in calculating the amount of the loss harvested for tax purposes.
**Note that the secondary ETF was sold and the primary ETF was purchased in these tax-loss harvesting trades because of previous trades in which the primary ETF had been sold and the secondary ETF purchased. Source: Charles Schwab Investment Advisory, Inc.

How volatility can work for you

While financial markets are volatile by nature, prepared investors can take action to help make these inevitable fluctuations work for them. Sophisticated portfolio management services such as tax-loss harvesting may help reduce investment taxes and can leave you more money that can be reinvested with the potential to grow over time. With Schwab Intelligent Portfolios, automated tax-loss harvesting is available for accounts with at least $50,000 in investable assets.

By David Koenig, CFA®, FRM®, Chief Investment Strategist, Schwab Intelligent Portfolios