By Rudy Aguilera -Principal, Helios LLC
As the April 15th income tax filing deadline approaches, you may wish to sit down with your clients and discuss the ways you can reduce the tax obligations of their investment portfolio. We refer to this as “tax alpha” at our firm and it is a predictable source of value that you can deliver to your clients. Regrettably, both advisors and clients are often guilty of focusing solely on returns. There is no question that returns are the primary driver of performance. However, if a significant portion of that return is eroded by taxes, then you have to question the amount of risk the portfolio is assuming in order to generate that rate of return.
So we are left with a question -- How can we increase the after-tax rate of return on our clients’ investment portfolios?
The answer lies in a technique known as tax-loss harvesting, which is simply realizing losses in a portfolio to offset any current or future gains. The motivation behind the strategy is quite simple. By recognizing losses in order to offset gains, there is no immediate tax liability. Capital that would have otherwise been spent on a tax bill remains instead fully invested in the portfolio. In effect, your clients receive an interest-free loan from the government.
The mathematical nature of compounding makes tax-loss harvesting a valuable option for taxable investors. In fact, the most widely quoted study concluded that a portfolio can accumulate 1400 basis points of cumulative tax alpha just from systematically harvesting losses over a twenty-five year period.1 Imagine adding 14% to your clients’ after-tax terminal account value by deferring a significant portion of taxation on their portfolio. In addition, by building up a bank of losses from which to draw, you can liquidate appreciated positions without incurring capital gains taxes as your clients retire and turn to their investment portfolios to replace their income.
Many of you reading this article may feel that tax-loss harvesting is just treating a symptom of a far more severe condition -- losses. Realize that we are viewing this at the asset class level and not the security level. A broadly diversified portfolio will include a number of non-correlated holdings that will rarely move in tandem. Therefore, there will always be an opportunity to harvest a short-term loss, whether it is on shares acquired through the reinvestment of dividends and interest, or those resulting from additional contributions to the account.
What is the biggest impediment to harvesting a loss? The wash sale rules, which prohibit realizing the benefit from a loss deduction if purchasing the same, or a substantially identical security, thirty days prior to or thirty days after realizing the loss. Before we delve into some techniques that can allow you to maximize the benefit of tax-loss harvesting, we need to address a few of the pitfalls that often ensnare advisors.
The financial services industry has long emphasized the importance of portfolio rebalancing. Judging from the numerous advisors I have encountered over the years, the majority appear to rebalance client accounts on an annual basis. If an account is rebalanced only once per year, a number of loss harvesting opportunities may be overlooked. Furthermore, short-term losses are transformed into long-term losses, which have significantly less economic value. Therefore, a tax-loss harvesting campaign must be viewed as a dynamic and fluid process, not a static and rigid ritual undertaken once per year.
I have also seen a number of advisors recommend taking a loss on a position in a taxable account, while purchasing the same security in an IRA. As usual, the IRS is one step ahead. While an IRA is a separate entity shielded from taxation, it remains a related party. Under the current tax code, if your client sells a security at a loss in a taxable account and then purchases the same security in their IRA, your client loses the economic benefit of the loss.2
If you rely on mutual funds within your practice, you must understand that there are two cost bases involved. As a shareholder, one has an external cost basis representing the purchase price of the fund shares, but the fund also has an internal cost basis representing the purchase price of the securities held within the fund. When securities are sold by the fund, shareholders are responsible for the payment of taxes on any ensuing gains. Consequently, one needs to harvest losses prior to receiving a distribution from the fund in order to preserve the character of the loss.