Bear Market Has You Counting Losses? Turn Them into Tax Breaks
Michael Jabara: Hello and welcome to another edition of Wealth Management Insights. I’m Michael Jabara, co-head of Global Investment Manager Analysis, also known as GIMA, for Morgan Stanley Wealth Management, and I am recording this on Friday, November 11.
It may be an understatement to say it’s been a rough year for financial markets. Even considering some recent gains, markets have been battered by forces ranging from anxiety around inflation to worries about a recession, alongside one of the most aggressive monetary-tightening programs in modern history. Year-to-date, the S&P 500 Index is down about 16%; the Nasdaq is faring even worse, down about 29%; and the Bloomberg US Aggregate Bond Index is off by 14%.
These losses are painful, but we can try to make use of them. And this is where being tax-efficient can help. Remember that taxes can impose a meaningful drag on returns. To offset this impact, we encourage investors to consider tax-loss harvesting. This is a strategy that can help improve realized returns without adding substantially more risk to a portfolio.
So, what does tax-loss harvesting entail?
Generally, it involves selling positions that are losing money, and using those losses to offset some, or all, of your taxable gains. If your losses are greater than your gains, the harvested losses can also be used against ordinary income, for up to $3,000. Anything left over can be carried forward to reduce your tax liability in future years.
Tax-loss harvesting isn’t just for equities. Currently we’re actually seeing a rare opportunity to harvest losses across fixed income. Since inception in 1976, and prior to this year, the Bloomberg US Aggregate Index has seen only four years of negative total returns: in 1994, 1999, 2013 and 2021. It may make sense to harvest some losses in your bond allocations to offset future tax liabilities.
Whether in stocks or bonds, harvesting can be a good time to reassess your portfolio. If you’d like to maintain your allocation to specific sectors or asset classes, you can use the proceeds from the sales to swap into similar securities or investment vehicles. One important point here is to be careful not to run afoul of what are known as “wash-sale” rules that govern tax swaps.
You can also use harvesting as an opportunity to move out of securities or investment products with less potential and into investments that may present a more favorable opportunity. Think of it as a way to upgrade your portfolio, while using realized losses to your advantage.
Looking ahead, the investing landscape is likely to remain in flux. The Federal Reserve continues to tighten policy into an environment of slowing economic growth, and prospects are weakening for corporate earnings. Against this backdrop, it becomes all the more important for investors to have an “after-tax” perspective on their portfolios. And this is not just something to consider at the end of the year. We encourage investors to engage in active tax-related conversations with their Financial Advisors throughout the year.
Let me close with the reminder that taxes can erode a significant portion of your investment returns, especially over the long term, as they impede the power of compounding returns. But, on the flip side, tax reductions, even if small, can add up over time and make a significant impact on overall wealth accumulation. In fact, our analysis indicates that an improvement of a half a percent a year in after-tax returns can result in a wealth difference of 50% after 30 years of distributions.
Navigating tax implications may not be easy, but Morgan Stanley Wealth Management offers several resources to help. Our GIMA group has a number of tax-efficient investment options across asset classes. And our Tax Management Services team can help you actively manage capital gains. If you have any questions or would like to discuss harvesting losses from your own portfolio, please contact a Morgan Stanley Financial Advisor. Thank you for listening today.
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Tax-loss harvesting. IRS rules stipulate that if a security is sold by an investor at a tax loss, the tax loss will not be currently usable if the investor has acquired (or has entered into a contract or option on) the same or substantially identical securities 30 days before or after the sale that generated the loss. This so-called “wash sale” rule is applied with respect to all of the investor’s transactions across all accounts
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