Tax-Loss Harvesting: Be Tax-Smart All Year, Not Just at Year-End

With possible tax rate changes in the news, financial advisors are reminded it is important to embrace tax-smart investing strategies. Within multi-asset portfolios, being tax-smart includes systematic processes around tax-loss harvesting, minimizing wash sales, and managing the holding period and yield.

Many advisors focus on tax-loss harvesting—sometimes referred to as tax harvesting or loss harvesting. This is the act of selling an asset that is lower in price than its original cost-adjusted purchase price. This difference can be a loss that is harvested and used today or in the future to offset realized gains. Creating this loss is considered a tax asset and may 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.

For advisors’ taxable clients, the pre-tax return shown in quarterly performance statements can have little bearing on their ability to achieve desired financial goals. It’s the after-tax amount that will ultimately be available to these investors in the future. Productive tax-loss harvesting could make a big difference in deferring gains and maximizing after-tax returns for these investors.

One of the biggest obstacles to this strategy is often client perception. Investors don’t like hearing they’ve lost money, and the term loss-harvesting requires them to acknowledge an investment loss. In other words, to harvest losses, an investor must first admit they were wrong. So, psychologically, it can be difficult to tax-loss harvest. A systematic process can help overcome this bias.

For many advisors and their clients, loss harvesting is an exercise addressed just before the year is over. While this might be easier from a calendar planning perspective, investors may be missing other, more attractive opportunities throughout the year—not just at the end of the year.

Has year-end harvesting proven beneficial?

Since 1926, the U.S. stock market, based on the S&P 500 Index and looking at calendar returns, has been positive more than 70% of the time. Over the past 70 years, based on FactSet data, in terms of monthly returns:

• November has been the single-best stock market month.
• December has been the third-best stock market month.

In other words—on average—waiting until November and December to perform tax-loss harvesting may be limiting investors to two of the worst tax-loss months.

As the chart above shows, it’s important to actively manage for taxes throughout the course of the year to help ensure steps are taken to improve after-tax returns. It should not be an end-of-year exercise. Moreover, in addition to loss harvesting, there are more active tax-managed strategies available to mitigate the tax drag in investment portfolios. These also can be implemented throughout the entire year.

Considerations: timing and scale

Consider the 2020 bear market, which started and finished within 30 calendar days, the fastest ever. Advisors need to be ready to act—and to act quickly. As an advisor, you also need a systematic process to understand which clients may benefit.

Advisors don’t only work with one taxable account. The multitude of accounts an advisor manages translates to every investor having a specific starting point. Each investor’s cost basis is unique to them and the advisor needs to be sensitive to each situation. Add in the impact of distribution reinvestment, client withdrawals, and marginal tax rate changes—all for every client across your practice—and it gets complicated very quickly.

Common mistakes

In addition to waiting until year-end, quarter-end, or month-end, there are a few other typical mistakes advisors can make with do-it-yourself tax-loss harvesting:

1. 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 should you 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 advisors often want to keep the cash proceeds invested in the market, typically in a security with very similar characteristics to the original security. If purchasing a replacement security, make sure it has similar characteristics (such as market cap, style, industry, etc.) as the original holding—but is still substantially different. 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.
2. 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. Take the amount of loss harvested and multiply by the investor’s tax rate for short-term gains. That’s how much you are creating in potential tax savings or a tax credit. Again, this only works if you have current gains in the portfolio or can carry forward the loss into future periods.

Overall, when working with an investment solutions provider, it is important to look at the after-tax return that a tax-managed fund or model portfolios provide, instead of the pre-tax performance numbers. For tax-sensitive investors, what really matters is not what their investments earn, but what they get to keep, after taxes.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Frank Pape is a senior director in the Portfolio Consulting Group at Russell Investments.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.