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What active trading costs in tax, before it has beaten anything
Deferral is an asset and realising a gain spends it. The holding-period cliff, the cost of paying every year, and the hurdle before you outperform.
An unrealised gain defers its tax bill indefinitely and the deferred amount keeps compounding on your behalf. A realised gain pays every year, at ordinary income rates if the position was held under a year, and the tax paid is capital that never compounds again. That gap is the hurdle an active strategy has to clear before producing a single dollar of real outperformance, and at high turnover it is worth multiple percentage points annually.
Two rates separated by one day
United States federal rules split capital gains at a holding period of one year. Under it, the gain is short term and taxed as ordinary income. Over it, the gain is long term and taxed at the preferential rates, with the net investment income tax layered on above the income thresholds. The difference between the two treatments on the same profit is frequently larger than the difference between a good year and a mediocre one.
Because the boundary is a date rather than a judgment, it is one of the few things in investing that is fully within your control. It is also the reason a strategy with a holding period of eleven months is a materially worse version of the same strategy at thirteen, before anyone argues about whether the signal works.
Deferral is the actual asset
An unrealised gain is an interest-free loan from the government, and it stays invested. Sell and rebuy the identical position every December and you have changed nothing about your exposure while converting part of the balance into tax, permanently, every year. The lost compounding on that money is the real cost, and it grows with the horizon rather than staying constant.
This is why the comparison “my strategy returned 14% and the index returned 11%” is usually incomplete. If the 14% turned over four times a year at short-term rates and the 11% never sold, the after-tax ranking can reverse without either number being wrong. The strategy has to beat the index by its turnover cost plus its tax cost, and both are computable in advance.
Wash sales, and what harvesting really does
Selling at a loss and buying the same or a substantially identical security within 30 days before or after disallows the loss for that year. It is not destroyed: the disallowed amount is added to the basis of the replacement position, so the benefit is postponed rather than lost. People treat the wash sale rule as a trap. It is a deferral rule.
Harvesting itself is the same shape. A harvested loss offsets gains of the same character first, which makes it most valuable against short-term gains, and reduces the basis of what you now hold, which means a larger gain later. The benefit is real and it is a timing benefit plus a rate arbitrage, not free money. Harvesting a loss to offset a gain you would have deferred anyway can leave you worse off.
- Check the holding period before selling anything close to the one-year line.
- Compute the after-tax return of both strategies, not the pre-tax one.
- Track basis after any harvested loss, because it moved.
- Put the highest-turnover part of the portfolio in the tax-deferred account first.
What to do about it
Our position: asset location is the cheapest improvement available to most taxable accounts, and it requires no view on anything. If part of your portfolio turns over frequently and part does not, and you have both a taxable and a tax-deferred account, the high-turnover sleeve belongs in the shelter. That single reorganisation is often worth more than the strategy debate it makes irrelevant.
Run the arithmetic before deciding an edge survives. The rules described here are United States federal rules and they change; the structural point does not. Tax paid early is capital removed from a compounding process, and any strategy that pays more of it has to earn the difference back before it starts winning.
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