So far, 2016 has been eventful for many investors. After more than three years of low volatility across equity markets, we’ve seen a sharp rise in volatility largely driven by declining oil prices, concern around Chinese economic growth and emerging markets as a whole.

On top of that, the U.S. Federal Reserve finally raised interest rates for the first time in almost a decade at the end of 2015. The coverage up to the Fed’s year-end decision drove additional uncertainty, market movements and further speculation about the timing and magnitude of future rate rises in 2016. Through this uncertainty, returns are expected to be somewhat modest over the course of 2016, meaning financial advisors will need to work even harder and consider all possible investment options.

Taken together, these macro events signal a busy year for advisors. With the recent market volatility, many may not have considered a key way to turn market shifts to their clients’ advantage for taxable accounts—tax-loss harvesting. When implemented correctly and in certain situations, declines in client portfolios can be made into tax benefits, allowing advisors the potential opportunity to turn a portfolio decline into improved returns for their clients when taxes are taken into consideration.

Talking About Tax

It may seem counterintuitive that down markets may help improve portfolio returns. However, selling down assets and harvesting the losses for tax purposes can do exactly that by simply diminishing the overall tax burden on the portfolio.

And the opportunity is there. Using the same source and methodology found in the article, “Taxes: What A Drag,” by Russell Investments, the average tax drag on U.S. active and passive equity investments over the past 10 years (ending on Dec. 31, 2015) was 1.23 percent. Over the same period of time, average U.S. equity mutual fund expense ratios were 1.21 percent. Yet, many advisors focus on performance and expense ratios, without giving much thought to taxes when developing their clients’ portfolios. 

While expense ratios are important to consider when evaluating mutual funds, tax drag is a hidden expense ratio which many advisors overlook or may not even consider for their taxable accounts. While 1.23 percent per year may not sound compelling, reducing this expense ratio can have a material impact on an investors’ after-tax wealth. Imagine reducing a 1.23 percent tax drag by 75 bps. Over a 10-year period, the compounding effect represents a cumulative 7.8 percent improvement in after-tax returns—a significant amount many investors may not be considering.

Nevertheless, advisors and their clients are barely discussing taxes. Russell Investments’ Financial Professional Outlook (FPO) survey findings, released in August of 2015, report that while 53 percent of clients saw a larger tax burden in 2014, dialogue about tax strategies decreased. Furthermore, only 22 percent of advisors considered taxes as one of their most common topics of conversation with clients that year. By all appearances, advisors are missing a key opportunity to improve client outcomes.

The Opportunity At Hand

Market volatility underlines an opportunity advisors may be missing to improve outcomes for their clients. Of course, all investments have a certain amount of natural volatility baked in—whether they’re funds or stocks or anything else. Depending on the level of volatility, advisors can lean into naturally occurring shifts in stock or fund prices in an attempt to create tax benefits. In certain situations, these benefits can then be carried forward and applied against future gains with the goal of improving after-tax returns.

Let’s be clear. The goal is not to avoid any and all taxes. The goal should be working to create higher after-tax wealth. Avoiding taxes is not a financial plan. Managing taxes in a thoughtful, holistic way should be part of a larger portfolio strategy working towards a desired investment outcome.

Beyond potential improved returns, tax-managed investing strategies can be a key point of differentiation for many advisors. Given the recent FPO survey responses, many of their peers may not be paying enough attention to these strategies either.

In sum, holistic tax-management can be a vital part of an advisor’s offering, further improving portfolio performance and client relationships in general.

Key Considerations

It’s no secret that getting clients on board with a strategy which involves selling an investment at a loss can be challenging. The idea that a tax benefit, created by selling at a loss, may carry value for a portfolio is not intuitive for many investors. As a result, advisors need to be sensitive to client concerns, while seeing the opportunity to demonstrate their value and discuss their strategic reasoning behind their decisions.

As always, every individual case is different. This is especially true when it comes to tax-management, as factors including client cost basis, tax bracket and other unique circumstances which may need to be considered to fit the client’s specific situation.

That said, tax-management does not apply to only the super wealthy. Consider a married couple with a taxable income of $74,900. Their marginal tax rate is 25 percent. Think about that! For every incremental dollar of taxable income above $74,000, $0.25 goes to federal taxes. The tax rate can go as high as 43.4 percent for those in the top bracket when you also include the 3.8 percent Net Investment Income Tax many investment earnings receive.

As is often the case, the first step for advisors is creating a dialogue with clients. Russell Investments’ FPO survey, released December of 2015, has found that both investors and advisors are focused on volatility and hold a somewhat pessimistic view of the economy. Yes, it’s vital for advisors to work and address these concerns. But that’s only part of the task.

The next step is to encourage clients to think strategically. Again, volatility can actually play to an advisors’ advantage when discussing tax issues, because the attached opportunity at-hand is to harvest losses. Taking a step back, the key is to create a holistic portfolio and a successful tax-management strategy.

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.