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It’s not even August, but when it comes to maximizing tax efficiencies and minimizing clients’ burdens to the IRS, it’s never too early to start planning.
That process should include tax-loss harvesting. 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.
Plus, it’s easy to explain to clients. That’s important because tax implications are one of the primary reasons clients work with advisors. Tax-loss harvesting is the act of selling a losing position to offset some of the capital gains obligations on profits on a winning trade. In an effort to make some lemonade out of lemons, advisors have ample tax-loss opportunities to consider over the near-term.
Although stocks and bonds are rebounding this year, no advisor nor client is perfect, which is to say chances are some clients have some duds in their portfolios that can be expelled for the purposes of tax benefits.
Tax-Loss Harvesting Strategy
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.
“Since U.S. investors are taxed on net capital gains, offsetting capital gains with capital losses can lower your taxable income (provided you’re a U.S. taxpayer),” notes Dan Hunt, Morgan Stanley senior investment strategist. “Let’s say that I earn a profit of $30,000 by selling Fund A. Meanwhile, I notice that Fund B is down by $15,000. By selling Fund B, I can usually use those capital losses to partially offset my capital gains from Fund A—meaning I’d only owe taxes on $15,000 of profit instead of $30,000.”
By “harvesting” that $15,000 loss and redirecting the capital to another investment (it can’t be close to the initial product) proper asset allocation is maintained and the advisor delivers tax synergies to the client. It’s a win-win. Speaking of winning…
“Your losses don’t just offset your gains; they can also offset up to $3,000 of ordinary income each taxable year. Let’s say I still realized a profit of $30,000 from Fund A,” adds Hunt. “But in this scenario, Fund B lost $33,000. Assuming I had no other capital gains or losses for the year, I could use my loss to offset my entire gain from Security A, plus I could offset $3,000 of my ordinary income, further reducing my current income tax liability or possibly increasing my tax refund.”
Wash Sale Rules: Thorny Tax-Loss Harvesting Issue
As is the case with anything in financial markets, there are some issues to be mindful of with tax-loss harvesting. Namely, the advisors needs to be well-versed in IRS wash sale rules to keep the tax perks intact. Put simply, if the advisor sells Coca-Cola (NYSE: KO), Pepsico (NASDAQ: PEP) shouldn’t be purchased inside of 30 days.
“Basically, it says that I can’t sell Security B and then immediately buy it back again just to get the tax benefit, and if I do so, the capital loss will be deferred. I am, however, allowed to claim the loss currently if I sell one stock and buy another one in the same industry—just not stock in the same exact company as before, or another investment the IRS would consider “substantially identical” to the one I sold,” concludes Morgan Stanley’s Hunt.
Related: How Advisors Can Help Clients Avoid Financial Regrets