Tax loss harvesting sounds like a magical strategy that is only available to the wealthy. But in reality, it’s a simple tax saving concept that involves selling a security or investment that has experienced a loss, and using that ‘capital loss’ to offset a capital gain in the past, present, or future.
Investors should know that tax loss harvesting is only relevant when it comes to investments held in their taxable or non-registered accounts. You can use a capital loss to reduce a taxable capital gain this year, in any of the three preceding years, or in any future year. That’s a powerful tool that savvy investors and investment advisors can take advantage of to reduce tax exposure.
Also, know that a capital loss is not realized until the asset (be it an investment, or a property) is sold for a price that is lower than its original purchase price.
Tax Loss Harvesting for DIY Investors
DIY investors can create their own strategy for tax loss selling. Let’s say at the beginning of the year you purchased $100,000 worth of VCN – Vanguard’s Canada All Cap Index ETF. Today, VCN is down 12.9 percent. You sell your shares of VCN and realize a loss of $12,900.
But you’re not done yet. After selling VCN you immediately buy a comparable ETF such as iShares Core S&P/TSX Capped Composite (XIC). You’re still fully invested, but you’ve “harvested” a $12,900 capital loss to hopefully offset a capital gain at some point, and now you get your Canadian equity exposure from XIC instead of VCN.
Buying a comparable fund gets around CRA’s ‘superficial loss’ rule, which states that investors can’t repurchase the same property or security for 30 days. A lot can happen in one month, as we’ve seen recently, and so we don’t want our money sitting on the sidelines.
The other concept for investors with taxable accounts to understand is their adjusted cost base (ACB). More than just the original price you paid for an investment, adjusted cost base also factors in any new purchases, plus any reinvested dividends or capital gains distributions, minus any sells or return of capital distributions.
Simply put, it’s a pain for self-directed investors to keep tabs on their adjusted cost base, plus come up with their own approach to tax loss selling that’s timely, profitable, and onside with CRA.
So, what’s an investor to do if he or she wants to take advantage of tax loss harvesting without the pain of managing it on their own?
Tax Loss Harvesting with Wealthsimple
The remainder of this article will look at how the robo advisor Wealthsimple handles tax loss harvesting for its clients. It’s a feature that’s widely promoted as a benefit to investors, but as you’ll see it only makes sense in a few circumstances.
Related: Using a robo-advisor in retirement
I spoke with Michael Tempelmeyer, a senior investment and retirement specialist at Wealthsimple, to better understand how the robo advisor uses tax loss harvesting for its clients.
He says tax loss harvesting is available to clients who qualify for the Wealthsimple Black or Wealthsimple Generation premium service levels by having net deposits of $100,000+ and $500,000+ in their Wealthsimple account, respectively.
Tax loss harvesting can be activated for these clients and applies to personal investment accounts and corporate investment accounts, both of which are taxable account types.
“Our approach to tax loss harvesting is simple. Any time one of the eligible ETF positions in a client account falls 7 percent below the amount that was paid for it, we will sell the position to realize the capital loss for tax purposes,” said Tempelmeyer.
They take the proceeds of this sale and invest the money in another similar, but not identical ETF, so the client maintains their desired market exposure.
For the majority of the individual ETF positions used in Wealthsimple’s 11 standard risk level portfolios there is a backup ETF on standby for this purpose.
However, there are a few ETF positions used in their standard portfolios that don’t have a viable backup position. In these cases, as well as in their Socially Responsible Investment (SRI) portfolios and their Halal portfolios, they are not able to do any tax loss harvest selling.
Tax Loss Selling in Action
Tempelmeyer said that during the recent decline in markets, as a result of the COVID-19 pandemic, there were a number of tax loss sales in client accounts where XEF (BlackRock iShares Core MSCI EAFE IMI Index ETF) was sold.
“We use VIU (Vanguard FTSE Developed All Cap ex North America Index ETF) as a backup position in this case. VIU tracks a different index but has very similar geographic exposure to XEF,” said Tempelmeyer.
There were two particular cases where this decline in the unit price of XEF created a good tax loss harvesting opportunity for two different clients in very different situations.
1) Linda who is a 35-year-old technology company employee has $1.5 million in a personal investment account with us. The account is invested in our risk level 10 portfolio which has 90 percent exposure to stock markets and 10 percent exposure to bond markets. The tax loss sale of XEF realized a total capital loss for her of approximately $30,000.
2) Ray who is a 47-year-old business owner has $2.9 million in a corporate investment account with us. The account is invested in our risk level 6 portfolio which has 65 percent exposure to stock markets and 35 percent exposure to bond markets. His business realized a capital loss of approximately $40,000 as a result of the sale.
What this means is that the next $30,000 of capital gains realized personally for Linda and the next $40,000 of capital gains realized by Ray’s business will be tax-free. If there are no capital gains this year or in the three prior years to be offset, then the capital losses that were realized can be carried forward to be used against capital gains in any future year.
“The benefits of tax loss harvesting make sense for the vast majority of people with taxable accounts and I generally recommend taking advantage of this strategy, but it is always a good idea to talk through the specifics of an individual situation with a financial planner who understands the potential implications,” said Tempelmeyer.
Changing Your Asset Mix
A market downturn can also provide an opportunity for investors to make a shift in how their portfolio is structured at a reduced tax cost.
Many investors can feel trapped in a particular strategy due to the unrealized capital gains that they would be taxed on when selling.
While Mr. Tempelmeyer thinks it makes sense to move away from a high cost or inappropriate asset mix portfolio essentially any time, a downturn provides the opportunity to do this more efficiently from a tax cost perspective.
Investors who should review their options include those who hold high cost mutual funds or other costly advised portfolios as well as investors who continue to hold concentrated positions in individual stocks for the sole purpose of avoiding the tax hit associated with selling.
Individual investors can use tax loss harvesting or selling to save taxes on past, present, or future capital gains. In fact, the recent market crash due to the coronavirus pandemic likely highlights a terrific opportunity to take advantage of tax loss selling.
Managing your own non-registered portfolio and creating your own tax loss selling strategy means diligent and tedious tracking of your adjusted cost base, ensuring your selling and re-purchasing is onside with CRA’s superficial loss rules, avoiding market timing, and identifying the appropriate time to crystallize a loss that best benefits your tax situation. Whew.
This is where a robo-advisor can come in handy. At Wealthsimple, once you’ve turned on the tax loss harvesting feature then it is happening automatically behind the scenes whenever one of a client’s ETF positions falls 7 percent below its original purchase price.
It can also work for clients with specific tax loss harvesting opportunities, like when they’ve transferred over a non-registered portfolio in-kind from another institution and need to carefully and methodically sell off the portfolio over time.
Did you know Boomer & Echo readers get a $50 cash bonus when they open up a new Wealthsimple account and fund it with $500 within 45 days? Transfer your account to Wealthsimple and they will cover the transfer fee.
Readers: Are you looking at tax loss harvesting opportunities due to the recent market downturn? How comfortable do you feel managing it on your own versus using a robo advisor?