With less than two months left in 2023, now is a perfect time for advisors to start strategizing for client tax benefits. An effective avenue through which to accomplish that objective is via tax-loss harvesting.
It’s not a new concept and it’s one many advisors are already aware of and deploying on a yearly basis. In simple terms, tax-loss harvesting is the act of selling a losing position to offset capital gains liabilities incurred when realizing profits on a winning position. Tax-loss harvesting is indeed a strategy, meaning implementation is of the utmost importance. Clients won't derive much benefit from blindly selling a stock or a fund simply because it's in the red this year. After all, it could be a legitimate rebound candidate and if the client moves into something else that's comparable to the sold position, he or she could run afoul of IRS wash sale rules.
Speaking of the wash sale rule, it’s also easy to interpret. Put simply, advisors attempting to gain tax benefits for clients by selling a losing position to offset capital gains from a winning trade cannot deploy capital from the loser into a security that’s essentially similar. In a hypothetical example, the wash sale rule would likely be violated by using Microsoft (NASDAQ: MSFT) to offset capital gains and turning around and buying Apple (NASDAQ: AAPL).
Looked at another way, using individual securities for tax-loss harvesting purposes can be a pain and invite tax issues, not benefits. Don’t worry because exchange traded funds (ETFs) are ideal for tax-loss harvesting.
Tax-Loss Harvesting Made Easy with ETFs
Diversification, which has long a source of allure with ETFs, is one of the primary reasons the asset class is idea for use as tax-loss harvesting tools.
“ETFs, comprising diversified portfolios, offer greater ease in finding identical tracking objectives, such as large-cap or tech-only stocks, while adhering to different underlying indexes to avoid breaching the SEC rule,” notes Vanya Sharma, capital markets associate at WisdomTree.
In simple terms, tax-loss harvesting is a considerable value add for clients because they likely fall into one of three groups 1) aren't aware of it in the first place 2) know about it and don't know how to implement it or 3) are wanting to hold onto a losing position and don't realize there are benefits to parting ways with that laggard. Here’s another handy, hypothetical example of tax-loss harvesting in motion.
“Let’s assume Investor A just sold 500 shares of a food and beverage company. Investor A chooses to put the post-sale cash into a broader food and beverage sector-focused ETF. In doing so, Investor A avoids the wash-sale rule without compromising the portfolio’s original investment thesis and diversification,” adds Sharma.
Tax-Harvesting Ideal Value-Add
It’s often said that life’s two certainties are death and taxes. It’s safe to add clients’ desire for tax mitigation to that list.
With that in mind, helping clients lower tax tabs is an ideal way to improve client retention and bring value to the table. So it’s worth considering ETFs as avenues for tax-loss harvesting.
“Enhancing the bottom line involves more than solely capital gains. A discerning and efficient investor places great emphasis on using all available resources, including tax-loss harvesting,” concludes Sharma. “Tax-loss harvesting serves as a tax-engineering tool to mitigate both short-term and long-term tax liabilities. However, it is important to note that it may result in tax deferral at a later period instead of an immediate tax break. This approach carries the risk of higher taxes in the future. Nonetheless, we believe it remains a wise method to reduce the tax burden on your finances and improve your bottom line.”