An Empirical Evaluation of Tax-Loss Harvesting Alpha
14 Pages Posted: 3 Apr 2019 Last revised: 27 May 2019
Date Written: March 5, 2019
Advances in financial technology have made tax-loss harvesting strategies potentially more feasible for retail investors. We evaluate the magnitude of this "tax alpha" using historical data from the Center for Research in Securities Prices monthly database for the 500 securities with the largest market capitalization from 1926 to 2018. Given long- and short-term capital gains tax rates of 15% and 35%, respectively, and assuming investors have short-term gains or ordinary income to offset short-term losses, we find that a tax-loss harvesting strategy yields a geometric average of 1.10% per year from 1926 to 2018. However, this tax alpha is highly variable: over four successive 23-year periods, the tax alpha ranged from 0.57% to 2.29% per year, increasing in periods with higher volatility, higher dispersion of the individual returns, and lower overall return for the market. Although tax alphas are mostly positive, the largest magnitudes occur in years when investors are least likely to be able to make use of them immediately, i.e., when most equity investments are down. Since investors seldom have enough short-term gains to offset short-term losses and there are often limits to the amount of loss that can be carried forward or deducted against ordinary income, the tax alpha should be discounted accordingly. Indeed, with a constant marginal tax rate of 35% applied to all gains, the tax alpha across the entire historical sample decreases from 1.10% per year to 0.51% per year.
Keywords: Tax-Loss Harvesting; Tax Optimization; Tax Alpha; Tax-Aware Investing
JEL Classification: G11, G12, H26
Suggested Citation: Suggested Citation