As the 2020 election campaign ramps up, many presidential hopefuls are sharing their ideas on tax reform. Though some of the proposed initiatives seem unrealistic on a federal scale, many states have already started applying higher income tax rates to their top earners—known as the millionaire’s tax. When combined with the federal repeal of unlimited deductions on state and local taxes, this controversial tax greatly increases high-earner penalties.
With high earners looking to decrease their tax burden, generating tax losses has become an increasingly valued play among those impacted the most. For investors looking to prioritize the generation of tax losses, an aggressive approach to tax-loss harvesting may be the solution.
Let’s look at the millionaire’s tax and reducing the tax burden with a more aggressive approach to tax management.
What is the millionaire’s tax?
To increase revenue to meet various fiscal needs, many states have introduced—or are looking to introduce—an elevated income tax bracket for top earners. For example, New York added a temporary millionaire’s tax in 2009 to assist with fallout from the financial crisis, but the tax has continued well beyond its original three-year plan and has even been renewed to extend through 2024. For New York City residents, the top combined city and state tax rate is now 12.7%. In California the higher income tax rates start to impact residents at $250,000—peaking at 13.3% for the highest earners. Connecticut and Washington, DC, have also imposed a millionaire’s tax, and states such as New Jersey, Massachusetts, and Arizona are exploring similar options.
Reducing tax burden through tax management
Managing taxes for indexed portfolios can help reduce taxes by generating net losses that can offset other gains. Tax management is measured through tax alpha, which is the after-tax excess return minus any pretax excess return and fees.
For more than 25 years, Parametric has been managing Custom Core® portfolios that seek to provide pretax returns close to the benchmark and to outperform the benchmark on an after-tax basis. Our standard management of Custom Core accounts seeks a tracking error of 1% or less while realizing losses deep enough to cover transaction costs. For most clients, we’ve found the trade-off between tax alpha and tracking error to be appropriate. For clients with more need for near-term tax losses—such as those living in a state with a millionaire’s tax—a more aggressive approach to tax management may be suitable.
What is aggressive tax-loss harvesting?
Aggressive tax-loss harvesting places a greater focus on higher tax alpha by allowing the tracking error to drift to 2% instead of the 1% target on our standard portfolios. The widened optimizer takes on additional tracking error and creates the opportunity for increased loss harvesting, which realizes shallower losses and sells down greater portions of larger benchmark positions. While there’s a greater opportunity to harvest losses with aggressive tax-loss harvesting, doubling the expected tracking error doesn’t double the expected losses. The marginal tax alpha is highest between a tracking error of 0% and 1% since we harvest the deepest losses. Loosening the tracking error beyond 1% provides additional losses that aren’t as deep. The chart below demonstrates the relationship between tax alpha and tracking error.
Conceptual relationship between tracking error and tax alpha
Source: Parametric. Simulated data is hypothetical and provided for illustrative purposes only. The results generated by the simulation tool regarding the likelihood of various investment outcomes are hypothetical in nature, are based on assumptions that the user provided (which could prove to be inaccurate over time), do not reflect actual investment results, and are not guarantees of future results.
Is aggressive tax-loss harvesting worth it?
Under aggressive tax-loss harvesting, increasing tracking error to approximately 2% means there’s a 67% chance the return will be within 2% of the benchmark on either side. This increased tracking error means there’s a greater likelihood of larger excess return—positive or negative—than in a standard loss-harvesting mode. For this to be possible, portfolio owners must be comfortable with the increased likelihood of deviations from the benchmark return when choosing aggressive tax-loss harvesting. The chart below demonstrates the probability of return deviations of aggressive tax-loss harvesting.
Parametric portfolio return probability distributions for standard tax-loss harvesting
(1% tracking error) and aggressive tax-loss harvesting (2% tracking error)
SSource: Parametric. Simulated data is hypothetical and provided for illustrative purposes only. The results generated by the simulation tool regarding the likelihood of various investment outcomes are hypothetical in nature, are based on assumptions that the user provided, (which could prove to be inaccurate over time), do not reflect actual investment results, and are not guarantees of future results.
The bottom line
Our research and experience have shown the standard tax-loss harvesting mode to provide the appropriate trade-off between tracking error and tax alpha. However, for those living in states with a millionaire’s tax or others whose priority is tax alpha over tracking error, aggressive tax-loss harvesting provides a greater opportunity to generate tax losses to reduce an investor’s tax burden.
Jeremy Milleson, Senior Investment Strategist
Jeremy is responsible for assisting in the continued evolution of Parametric’s Custom Core® Strategies. He works closely with clients and advisors to design, develop, and implement custom portfolio solutions. Prior to joining Parametric in 2012, Jeremy worked as an instructor in economics at the University of Washington and also worked for Bernstein Investment Research and Management and Banc of America Investment Services. He earned MA and BS degrees in economics from the University of Washington.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.