For wine enthusiasts, the terms vintage or inception year define excellence, and they are equally significant to tax practitioners trying to harvest tax losses. Though complex and frequently misunderstood because of its emphasis on losses (unflattering cocktail party fodder at best), tax-loss harvesting offers the potential for significantly increased after-tax returns. It is a proven way of adding significant value to client portfolios on an after-tax basis, which is especially important for retirees on a fixed income. Yet, without a tax practitioner's ongoing client involvement and support, clients are unlikely to achieve the benefits of tax-loss harvesting.
Let's take a few moments to look at the practice. Purchased securities that fall below their initial price or basis may be sold as a way of realizing losses (referred to as harvesting a loss). Short-term realized gains and losses are those held for less than a year, while long-term gains are those held more than a year. Harvested tax losses can then be used to offset gains realized elsewhere in the portfolio in current or future years (though limitations exist). Long-term gains are taxed at about half the rate of short-term gains. (The highest rates for each are 20% for long-term capital gain and 39.6% for short-term capital gain, which is taxed the same as ordinary income.) Further, in a portfolio that lacks long-term losses (that could be used to offset long-term gains), the more valuable short-term losses must be used to offset long-term gains.
Many investment management professionals focus only on pretax returns, as this is how peer performance is measured. As a result, loss harvesting is typically a once-a-year undertaking (occurring late in the fourth quarter). Further, investment advisers often find tax-aware best practices, especially tax-loss harvesting, a challenge. A primary objective of tax professionals and investment advisers alike should be to actively postpone the realization of taxable gains, especially short-term gains, while maximizing each client's realized losses. Clearly, having more dollars invested for a longer time nearly always provides an improved result. Regrettably, this objective is rarely achieved.
Through the use of separately managed accounts (SMAs) in taxable portfolios (unlike mutual funds and exchange-traded funds (ETFs) where each sale is representative of all underlying securities), clients can harvest their losses on a security-by-security basis. Another important element, having the client elect to use highest-in, first-out (HIFO) inventory accounting should ensure the upfront tax bite on realized gains is minimized. The HIFO method treats securities purchased at the highest price as the first sold no matter the purchase date.
Further, unlike most investment management activities, tax-loss harvesting benefits from periods of elevated market volatility and/or declines. According to a study performed by Parametric Portfolio Associates, tax-loss harvesting of stock market index structured SMAs can enhance annual after-tax returns by as much as 2% in flat markets and about 1.5% in normal return markets over a 10-year period.
Tips on how to improve your results:
- Harvest losses often, whenever the opportunity presents itself throughout the year. A growing number of asset managers have come to realize that tax-loss harvesting is a great way to differentiate by adding value to a client's portfolio on an after-tax basis. While more managers are willing to help clients harvest losses upon request, persistence is essential. Retaining a long-term disciplined approach will ensure continued results.
- As stock markets normally rise, the benefits of tax-loss harvesting tend to be front-loaded and specific to each client's funding date. Overall tax status, the reservoir of existing realized losses, and security-specific holdings issues will vary by client and must also be considered.
- Bear in mind that tax-loss harvesting results are market dependent. The direction the market travels because of ongoing price discovery is sure to alter results. In addition to vintage, the unique type of managed portfolio (value, growth, or a representative index-like structure) will play a significant role in results. Growth-oriented portfolios tend to experience greater volatility and therefore may offer more tax-loss harvesting opportunities than value-oriented strategies.
- Avoid wash sale and other possible missteps, such as remaining in cash or "naked" through a combination of core portfolio simplicity, disciplined replacement, and fewer, yet more concentrated, SMAs. A wash sale occurs through purchasing a substantially identical stock within 30 days of the sale of the security, and Sec. 1091 denies a loss deduction in this case. Alternatively, maintaining a "naked" cash position throughout a wash sale is an inappropriate form of market timing. Lastly, if multiple core SMA portfolios are employed, security holdings overlap should be avoided.
- Evaluate all investment returns from an after-tax perspective. Although investment advisers and asset managers often have little concern for an investor's unique tax situation, taxes can play an outsized role in client outcomes. Transaction costs, including taxes, can be minimized by selectively altering and/or rebalancing the client's portfolio to meet objectives. A focus on each client's specific objectives rather than the adviser's one-size-fits-all "model" portfolio is vital.
Today's fully priced stock market may place investors at increased risk of volatility or even decline. Further, recent elections have elevated political risk and uncertainty; this could lead to heightened volatility for the next several years. While taxes alone should never drive investment decisions, a thoughtful approach to tax-loss harvesting should result in a significantly improved client outcome.
Poorly understood by clients and often overlooked by advisers, tax-loss harvesting is one of the best ways to add value in a market that is experiencing lower returns or is otherwise challenging. As any sommelier will tell you, the vintage of a wine is of utmost importance when ordering the right wine or when trying to impress your date. The same is true with tax-loss harvesting.
Maximizing client portfolio losses while minimizing gain realization, especially for retirees, is often the tax professional's responsibility because many investment advisers are reluctant to undertake the task or are unfamiliar with the process. Clearly, without a committed tax adviser, a client is unlikely to achieve the benefits of tax-loss harvesting (as well as all other tax-aware best practices).
Steve Riley and Rick Furmanski are portfolio managers at Clearview Wealth Solutions in Lake Zurich, Ill.