Maximize Gains, Minimize Taxes: The Case for Tax-Loss Harvesting in Model Portfolios

But like trees, model portfolios can grow unwieldy if not managed properly. Allocations don’t stay static as the market ebbs and flows.

With that in mind, model portfolios thrive when they are actively pruned via tax-loss harvesting. Investors can reduce their tax outlay and improve the returns and efficiency of their model portfolios.

Tax-loss harvesting is best described as an analogy. Think of your portfolio like a tree, growing from a sapling to a large oak over time. Over decades, most trees don’t grow straight up toward the sky and look “picture perfect.” Branches break, shoots can form in nonideal locations and weather conditions can create uneven growth. To spur new growth and keep the tree healthy, you would trim off dying branches and any diseased limbs.

Tax-loss harvesting is very similar in terms of a portfolio.

The basics involve selling an asset you own — a stock, ETF, or bond — that is currently losing money in a portfolio. The losses from that investment can be used to offset any gains you have had that year. So, if you own the SPDR S&P 500 ETF Trust and you are currently down $1,000 on it, you could sell it to offset a realized gain in another ETF or investment. By doing so, you lower your overall taxes for the year and increase long-term gains.

Even better is that if your capital losses exceed the gains or if you have no capital gains in a year, $3,000 worth of those losses can be used to reduce your ordinary income. And if you lose more than $3,000 on a stock, the excess can be pushed into the future to offset capital gains and ordinary income later on.

According to a recent study by Vanguard, tax-loss harvesting can potentially boost a portfolio’s value by around 0.5% to nearly 4% over the long run depending on the initial allocation, with the average investor seeing a 1% increase in overall gains. ¹

With the potential for extra long-term gains, financial advisors, blogs and investment gurus have long espoused the virtues of tax-loss harvesting. Now with model portfolios becoming a standard framework for many investors, it’s time to move the conversation about tax-loss harvesting here as well.

And it turns out that’s a great idea.

The beauty of models is that they quickly add a plethora of asset classes and create an easy-to-follow allocation. The problem is that allocation does not remain static over time. Market fluctuations can wreak havoc and generate big losses, making them ripe for tax-loss harvesting transactions.

The win is that ETFs can work with models to keep allocations the same while being able to take advantage of tax-loss harvesting. This is because they can help overcome SEC wash-sale rules.

The wash-sale rule states that a “tax loss will be disallowed if the same security, a contract or option to buy the security, or a substantially identical security, is purchased within 30 days of the sale date of the loss-generating investment.”

However, ETFs can get around this due to the differences in their underlying indexes that essentially track the same thing. For example, there are numerous ETFs that track large-cap sectors of the market. But because of the different underlying indexes, they often do not run afoul of wash-sale rules. Here, models could take advantage of tax-loss harvesting and stay invested in a similar overall allocation. Another example, investors using a total market ETF with losses could sell and buy three ETFs tracking large-, mid- and small-caps separately.

Moreover, investors could book losses on a passive ETF and buy an active one to take advantage of the potential.

Another win is that many brokerages now offer $0 commissions on trades as well as offering fractional shares. This is one of the reasons why model portfolios have become big in the first place — they allow smaller investors the ability to build a complete portfolio for only a few dollars at a time. But with the elimination of trading costs, they, too, can take advantage of tax-loss harvesting even if it’s only a few dollars at a time.

Given the benefits of tax-loss harvesting to overall returns and long-term performance, it makes sense to start implementing it in your model portfolios. The question is by just how much and how often? The beauty of the usage of ETFs and their frictionless trading is that investors could, in theory, tax-loss harvest every day.

According to J.P. Morgan, they may want to do just that. This chart shows that portfolios can pick up an extra 0.33% in annual returns by switching from a monthly tax-loss harvesting strategy to a daily one.

Source: JPM

Leaps in technology have made it easy to automatically rebalance and take advantage of these daily loss-harvesting transactions.

However, even if investors aren’t willing to go that far, quarterly or semi-annual rebalancing and tax-loss harvesting make a ton of sense. Again, models offer an easy framework for allocations. If a portion has deviated too far from the initial allocation it is now ripe for tax-loss harvesting. Finding similar investments that track similar indexes isn’t very hard these days. A simple screen can produce hundreds of candidates that offer exposure to the same areas of the market without running into wash-rule issues.

Model portfolios are wonderful vehicles for creating allocations that work towards defined outcomes and goals. Unfortunately, due to market changes, those allocations often do not stay static. This makes them ripe for tax-loss harvesting. By using ETFs and efficiently harvesting losses, model portfolios can benefit, keep their allocations in check and produce better returns.

¹ Vanguard (July 2024). Tax-loss harvesting: Why a personalized approach is important