Something I can’t seem to get my head around. Question 22 from the Reading 11 asks, when is tax loss harvesting most effective. The answer says its when tax rates are high.
I went back to the reading and couldn’t quite wrap my head around this, since effectively, the total tax paid will eventually be the same. Do they mean it will be most effective in a growing tax rate environment?
I don’t have the book with me, but I don’t think its a growing tax environment.
If you assume tax rates stay constant, the PV of the tax savings today due to tax loss harvesting (or in reality, you’re cancelling out taxes that would otherwise be paid on taxable gains) will be greater than the PV of the taxes paid later (assuming you pay the taxes later, but that assumes you replace the loss with a gain that generates tax. So many effing assumptions).
Total tax paid will indeed be the same if tax rates stay constant over time, but here are two things to note…
Assuming high tax rates today (allowing you to pay less taxes today if you harvest your losses) you could reinvest these greater savings earlier , let compounding work in your favor, and eventually end up with more money than had you had a lower tax rates initialy and higher taxes later on.
You can still end up with a tax alpha if HIFO tax accounting is permitted. This allows for losses with the highest cost basis to be realized and harvested first, resulting, once again, in higher current savings that you can reinvest earlier and compound profits through time.
Let me know if this makes sense.
Tax Loss Harvesting is used best in high tax environment because the main purpose of this is to deffer taxes and reinvest.