Six ways many investors mess up tax-loss harvesting

The recent market volatility has many advisors reviewing client portfolios for opportunities to harvest or recognize any possible losses. Given the low volatility across equity markets over the past 3+ years, there has been little opportunity for productive tax-loss harvesting. Recent events have changed this. And even aside from market volatility, there’s a certain amount of volatility inherent in vehicles like stocks, bonds and mutual funds, which can be sources of tax-loss harvesting, too. Loss harvesting is the act of selling an asset that is lower in price than its original purchase price (adjusted cost basis). This difference can be a loss that is “harvested” and used today or in the future to offset against gains. Creating this loss is considered a tax asset and will help in deferring the recognition of gains (if you have them!) until later periods. Done correctly, this deferral of gain recognition is intended to increase after-tax returns and help maximize after-tax wealth. But, the process can be complicated. Below are 6 common mistakes investors often make, and where we believe advisors can really make a difference when it comes to effective tax-loss harvesting.

1. First, be aware the strategy exists – and who might benefit most from it!
   • Taxable clients, for whom the goal is to maximize after-tax returns, may stand to gain from successful tax-loss harvesting. For taxable clients, the pre-tax return shown in quarterly statements can have little bearing on a client’s ability to achieve their financial goals. It’s the amount after-tax that will ultimately help these investors get to where they are going. Productive tax-loss harvesting could make a big difference in deferring gains and maximizing after-tax returns for taxable investors.

2. Overcoming the fear of selling a “loser.”
   • Tax-loss harvesting forces investors to sell a security that has lost value – which is often hard to do because it goes against the grain of investor optimism. When the goal is focused on trying to maximize after-tax returns, this reluctance to sell needs to be overcome. However, the goal is not to just sell any security that goes down, but to make that decision as part of a broader, thoughtful approach.

3. Only harvesting losses at year end.
   • Many investors focus on harvesting losses only at the end of the calendar year, as a last-ditch effort to reduce their tax bill for the year. But, as the exhibit below shows, active loss harvesting is more rewarding when opportunities are seized as they afford themselves – not just at year-end.

U.S. equity: Russell 1000® Index. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

4. After harvesting the loss, being in cash for 31 days or choosing the wrong replacement security.
   • When you harvest a loss, you are selling a security. What to do with the cash proceeds from the sale? Some investors choose to hold cash while waiting 31 days before repurchasing the original security to avoid the wash sale rule. In a downward trending market, this may be a fine strategy. But generally advisors want to keep the cash proceeds invested in the market – typically in a security with very similar characteristics as the original security. If purchasing a replacement security, make sure it has similar characteristics (e.g. cap size, style, industry, etc.) as the original holding – but is still “substantially different” (see #5 below). Also, consider whether the client’s asset allocation needs have changed? If not, avoid introducing any unintended risks or deviations from your policy portfolio via the new security. At 31 days or later, consider reverting back to the original security – if the investment rationale still holds.
5. Buying a similar security and having the loss disallowed.
   • When making the sale and purchasing a replacement security, make sure the replacement security is “substantially different” in character. Some aspects to pay attention to include fund share class, benchmark, security type, etc. The IRS can be very particular in regards to the new security being different in nature than the original purchase. If the securities are too similar, the loss may be disallowed, causing the entire effort to be of no avail.
6. Making sure the juice is worth the squeeze (understand the materiality).
   • 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% for short term gains (39.6% + 3.8% 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.