SMSFundamentals | Jan 30 2023
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Significance of "Tax-Loss Harvesting" for Australian Investors
By Anuj Sharma
2022 was a significant year for the financial markets, in which numerous macroeconomic adversities came together to test market valuations, and investors holding equities, bonds, or cryptos in their portfolios have endured larger-than-expected losses. Few assets (such as energy stocks) managed to end up in the green zone. In 2023, the financial markets are recovering from the bottom but still experiencing elevated levels of volatility. Tax-loss harvesting can provide a spectrum of benefits to investors while repositioning portfolios.
- Investors experienced a substantial value decline in their portfolios that is yet to be covered.
- Tax-loss harvesting can help investors minimise their tax liability by strategically applying investment losses.
Tax-loss harvesting signifies selling a money-losing investment and acquiring another financial security as its replacement. The harvested investment loss can then be applied to minimise the tax liability applicable to investment gains or other taxable income.
When filing taxes, if there are no investment gains or excessive losses compared to gains, investors can lower their future tax liability by carrying forward the capital losses.
Performance of Different Asset Classes
As the financial markets made major bottoms in June-July and September-October, the state of capital gains and losses depends on the annual basis for investment followed by investors.
Investors following annual returns have experienced substantial capital losses in equities, bonds, and cryptos that can be offset with the capital gains in commodities and carried forward.
Investors who navigate their portfolios in line with the tax filing year are experiencing capital gains in equities, gold, and cryptos that can offset the capital losses in commodities.
Investment Implications of Tax-Loss Harvesting
One of the vital sources of alpha (stock-specific risk) in the portfolio is tax savings. Improved tax efficiency has more sustainability than generating excess investment returns in an uncertain economic environment.
Tax-loss harvesting and portfolio repositioning are naturally compatible with each other. While keeping a constant eye on the portfolio's performance, under periodic rebalancing, underperforming investments are ideal for tax-loss harvesting.
The tax environment incentivizes long-term investments rather than short-term buying and selling, as higher tax rates apply to short-term capital gains than long-term ones. Tax-loss harvesting is highly focused on offsetting short-term gains with losses to minimise investors' tax liability.
Tax-loss harvesting can deliver significant favour for traders who invest through strategies that require large turnover and more short-term gains and losses.
How tax-loss harvesting might work can be understood through a hypothetical example.
An investor earns $120,000 a year, excluding short-term investment gains and losses, subjecting his capital gains to 37% tax. The investor is currently holding unrealised gains of $13,200 in an ETF tracking the ASX 200, while unrealised losses are at $4,200 in an ETF tracking natural gas futures.
Through tax-loss harvesting, the investor can close the position on the Natural Gas ETF and reduce the capital gains on the ASX200 ETF ($13,200 less $4,200) while reallocating the funds from the Natural Gas ETF into the ASX200 ETF. After harvesting losses, the investor's tax liability will be decreased by $1,554 (i.e., 37% of $4,200).
While applying tax-loss harvesting, investors must avoid “wash sales”. The Australian Tax Office restricts investors from selling a financial security during the year to benefit from a capital loss event, only to acquire the same security again in the next year. It is called a "wash sale." The Australian Tax Office disallows capital losses that materialise only to minimise tax.
The potential benefits from tax-loss harvesting depend on the magnitude of capital gains and the investor's tax bracket.
- Tax-loss harvesting is effective only when an investor plans to sell a highly appreciated investment that might generate a significant capital gain. Tax-loss harvesting is subject to the timing of portfolio rebalancing. The observed capital gains or losses might not be available at the end of the year.
- Tax-loss harvesting can support a material reduction of the potential tax liability if the investor's income belongs to a higher tax bracket. It will minimise taxable income by offsetting realised capital gains and carrying over excess capital losses into later years.
Selective and personalised portfolios on a long-term horizon require multiple scheduled changes. If investors plan to derive significant changes in the portfolio per their personal risk preferences, executing tax-loss harvesting will help improve portfolio structure.
Tax-loss harvesting is a vital tool for optimising financial planning and investment strategy. Investors experienced significant capital erosion last year, especially in stocks and bonds.
For investors, reduced taxes are an advantage, and if executed effectively, a tax loss harvesting strategy can support the minimization of current taxes and encourage more capital investment over time while reallocating funds into outperforming assets.
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