A Potential Tax-Loss Harvesting Pitfall
The decisions don’t end once a client has decided to become tax-aware and implement tax-smart investing strategies. Successful tax-loss harvesting is not an easy process, and partnering with a firm that can do this on behalf of clients may help better leverage an advisor’s time. Since tax-loss harvesting requires investors to sell an asset, they need to decide what to do with the proceeds from the sale. Hold cash? Identify a similar security? Or is it an opportunity to make a more meaningful change to the portfolio?
The goal is often to sell the security to harvest the loss and repurchase the same security. If so, know that the IRS requires investors to be out of the security for more than 30 days. A risk to holding cash over those 30 days is that if the market has positive returns, the investor may miss out. Another risk is identifying a replacement security. Advisors should make sure the replacement security is “substantially different” in character, as the IRS can be very particular. Some aspects to pay attention to include fund share class, benchmark, security type, etc. If the securities are too similar, the loss may be disallowed, causing the entire effort to be of no avail.
The key, though, is planning. Strategic preparation maximizes the potential benefits and minimizes possible risks. Again, it’s helpful for advisors to consider partnering with a firm that focuses on delivering tax-management strategies to better leverage their time.
Best Practices
For many advisors, taxes are really only considered or discussed at year-end or perhaps at “tax time.” This is a mistake. As we’ve noted on our Helping Advisors Blog, there are a number of best practices for advisors and clients alike that we think should be adopted year-round. We think of tax-loss harvesting as a year-round opportunity. This means keeping an eye out for opportunities and seizing them whenever possible—not just at year-end.
However, this isn’t a process you want to do every time a security goes down in value. Consider the size of the portfolio, magnitude of the downturn and costs related to the trades. If your client is in the top tax bracket, take the amount of loss harvested and multiply by 43.4 percent for short-term gains (39.6 percent + 3.8 percent for net investment income). That’s how much you are creating in potential tax savings. Again, this only works if you have current gains in the portfolio or can carry forward into future periods.
It also means taking an honest appraisal of both costs and benefits. For example, if the tax benefit that can be gained from a sale is less than the cost of the transaction, then the sale should not be made. More simply, “the juice should always be worth the squeeze.”
Other considerations around tax include paying attention to holding periods—in order to mitigate short-term capital gains, consideration of municipal bonds (generally tax-free at the Federal level) and qualified dividends vs. non-qualified dividends. As always, the key is to understand all available options and make the best decision for the individual portfolio.
The Bottom Line
Conventional wisdom pushes many to seek strategies which maximize portfolio returns by not selling when investments drop, due to the risk of missing out on potential future gains. However, when it comes to tax-management, an exception should be considered. While attempting to avoid losses, investors may be missing the opportunity to gain a tax benefit that can be used to offset current or future taxable gains.
Frank Pape is the director of consulting services for Russell Investments’ U.S. advisor-sold business.