Taxes are one area of investment management firmly in an advisor's control, unlike the direction of the markets, returns from various asset classes or the savings rate of a client. Investing with full knowledge of tax consequences is critical for portfolio performance, and tax-loss harvesting is one of the most useful tools in an advisor's toolbox. But has the tactic been over-hyped?
"There is less economic benefit to tax-loss harvesting than practitioners believe," says Prof. Kent Smetters of the Wharton School at the University of Pennsylvania. "There is a gulf between how economists think about this issue and how practitioners think about it."
Tax-loss harvesting involves selling securities at a loss to offset a tax liability from a capital gain. The core of Smetters argument is that harvesting merely pushes off the final tax bill. Although harvesting might look good in the short run, it increases the tax liability of the client because it essentially resets the basis price. "Advisors may intuitively understand all of this, but this still leaves the problem of reporting, which is even bigger," Smetters says.
The merits of tax-loss harvesting has been questioned by financial advisors for some time - yet there is broad disagreement, particularly among advisors with CPAs, who have been trained to take a loss automatically. The discussion has been murky, partly because abstract economic models almost always assume taxes and other "frictions" and rarely consider how investors should behave in a taxable environment. Also, institutional investors typically operate in a tax-advantaged world, meaning they don't focus as heavily on taxes.
RESETTING THE BASIS
As Smetters sees it, the downside of selling a stock for tax-loss harvesting - and then buying a new stock - is that it essentially means resetting the basis. When the new stock is sold, it will be taxed on the new and perhaps lower basis. The result: Tax-loss harvesting just means delaying a tax bill, not (with few exceptions) avoiding it.
Suppose you hold a stock you bought for $100 a share. Assume interest rates are near zero and tax rates remain constant. The stock falls to $60. You sell the stock and buy something similar (but not the same stock to avoid the wash rule) with the $60 a share proceeds, excluding commissions. You've captured a loss of about $40 a share, which you record as a loss against gains, reducing your tax bill. Such is the beauty of tax-loss harvesting.
But are you really better off? "Most tax advisors would say, 'Yes, you booked the losses against gains.' But actually there is a problem," Smetters says. Say the new stock you bought at $60 goes to $100 and you want to sell. The stock reflects the new cost basis of about $60 a share, meaning the investor now faces a capital gain of about $40 a share. If you hadn't sold the original stock, you wouldn't have the capital gain. (Of course, your original investment might never rebound, so selling may have been the best choice from an investment perspective.)
"With tax-loss harvesting, you are really just borrowing against your future tax bill," Smetters says. "You are taking a loss today, but you are paying for it with a capital gain."
Practitioners might argue they could invest the $40 a share they saved in something with high returns, say a high-yielding equity. Smetters argues the more accurate rate of return is a short-term Treasury. Of course, investors do gain some returns on the money they've saved through tax-loss harvesting. They keep accruing this interest until if, and when, they sell the asset and face the new cost basis. Smetters concedes, "You would be saving some money in present value, based on the interest, but you aren't saving much."
The more pernicious problem is one of reporting, according to Smetters. Investors may see the amount they have saved on their tax bill through tax-loss harvesting, but don't realize they have kicked the problem down the road. They are booking the asset without recognizing the increased liability.
"It looks like a better deal than it is," Smetters says. After-tax reporting is complicated, with two separate recognized approaches but advisors need to reflect the increased tax liability in some way. "I would keep it simple for clients, but the tax alpha could be as low as one-tenth as what advisors are currently reporting to clients."
THE OTHER ARGUMENT
"Tax losses have substantial value," counters Baylor Business School Prof. Bill Reichenstein, an expert on the tax consequences of investing. He uses his own family's portfolio as an example. Reichenstein harvested substantial losses in 2008 and 2009. These allowed him to write off $3,000 a year against income, saving him $840 in federal taxes each year, with multiple years of tax write-offs to come.
He reinvested the money he harvested in another tax-managed domestic stock fund that has gained 80%. Reichenstein expects that in perhaps 25 years this investment will receive a step-up in basis upon his death. His surviving spouse can use the money to provide for her retirement needs. He concludes: "We will avoid taxes on some 27 years and perhaps $600,000 of capital gains. I consider this significant."
The example reveals several loopholes that Smetters doesn't seem to consider. One is the offset against income taxes. In terms of capital gains, the core of his argument, if the acquired asset is never sold, the reset in basis is irrelevant. Instead, as Reichenstein's strategy demonstrates, by awaiting the step-up in basis until death, or donating the appreciated asset to charity, the investor can avoid taxes on the capital gains. In such cases, tax-loss harvesting is clearly worth it. This is no small loophole.
Smetters acknowledges his scenario rests on the assumption you will eventually sell the new asset with the reset basis and face the higher tax bill; it doesn't factor in the reset in basis upon death. But for active traders, this may not be relevant because they don't plan to hold stocks for the long run. And he argues most retirees use their assets for themselves and will cash in, rather than bequeath them.
The step-up in basis at death may not be guaranteed in the long term, Smetters says. "The step-up exemption only started because it was hard for people to track their cost basis. But if I were a politician needing revenue, this is low-hanging fruit. It could go away." Another factor: If clients' tax rates go up in the future, tax-loss harvesting now becomes even less valuable. "You wouldn't want to harvest losses now, you want to save them for the future when your tax bill will be higher," he says.
WHAT ADVISORS THINK
Pondering the different perspectives, Scott Schutte, vice president of financial planning and risk management at Commonwealth Financial Network in Waltham, Mass., recently surveyed advisors on the topic and found the outcome was a split decision. Half would automatically take a loss, while the other half would need more data before deciding.
"The majority of advisors are well aware of the resetting of cost basis involved in tax-loss harvesting," Schutte says. "But they are approaching the problem from different starting points." Advisors with tax backgrounds tend to harvest automatically; they are schooled in the concept of whenever there is a loss, take it. Yet those with a pure planning background look beyond the numbers to focus on broader needs of the client and also the assumptions about the future built into the scenario.
Schutte says he's in the second group. "I really would need to know more before automatically harvesting" - like a client's age and the possibility the assets will be bequeathed with a step-up in basis, as well as current and likely future tax brackets. The trading costs involved in harvesting are another consideration. "To harvest or not is a fascinating - and abstract - debate. It's important to look at the individual when making the decision," he says.
The economics behind tax-loss harvesting and the resetting of basis are relatively clear; how to best report the savings is much less so. "Some advisors might just communicate, 'I saved you x dollars on taxes this year,' whereas a fuller answer would include, 'But you will need to pay more taxes in future years because I have deferred that," says Stephen Horan, head of professional education content and private wealth at the CFA Institute.
After-tax performance reporting can take care of some of these issues. There are two methods, pre- and post-liquidation, both of which grew out of work at the Association for Investment Management and Research (now the CFA Institute) in the early 1990s. "Neither method can address all taxable scenarios. It depends on the situation you wish to apply them to," says Doug Rogers, author of the book Tax-Aware Investment Management, who participated in this initiative.
Pre-liquidation doesn't include unrecognized gains. According to Rogers, it is most appropriate when you have an instance such as the step-up in cost basis at death, where recognizing these gains is not relevant for taxes.
Post-liquidation is the value of the portfolio if all the gains were liquidated. It might understate the value of tax-loss harvesting because it doesn't include the time value of money that would accrue for any gains. But it is useful for assessing the eventual tax impact of selling such a position.
Post-liquidation is also useful for reporting on asset classes such as fixed income, where unrealized gains or losses are typically not a significant component of the overall total return. "While neither is perfect, understanding their nuances and best application lets investors make more informed decisions," Rogers says.
As Horan sees it, "All else being equal, deferring payment to the government as long as possible is sage counsel," he says, because even though the basis is reset, the gains grow until taxes have to be paid. "The net benefit of tax-loss harvesting is positive," he adds. "But because of the reset in basis, it isn't that big." Sounds a lot like Smetters.
David E. Adler contributes regularly to Financial Planning. His most recent book is Snap Judgment.