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
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)
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.
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.