Millions of investors are giving too many of their tax dollars back--often more than 40%--to Uncle Sam because of inefficient investing. Investors may not be able to escape taxation altogether. Even so, highnet-worth clients--as well as those in the 28% to 35% tax brackets--can reduce their burden with the help of financial advisers who utilize tax-loss harvesting.

Although there are numerous ways to create a tax-efficient portfolio, the single most important and effective method financial advisers can use to reduce a portfolio's tax liabilities is tax-loss harvesting. Basically, this involves selling securities to realize a capital loss, which is then used to offset capital gains. You can realize as many losses as necessary (assuming that you have the losers to sell, of course) to offset whatever gains were realized during the year.

Better still, capital losses generated for tax purposes can extend beyond capital gains. The tax code allows $3,000 in capital losses, unmatched with taxable gains, to be deducted from ordinary income each year. That's key for investors in high tax brackets, since the $3,000 results in a possible $1,050 (35%) federal income tax reduction. Losses of more than $3,000 can be carried over to future years, which is important for future gain and loss matching.

BEWARE THE WASH SALE

In order to do well by clients and develop a truly tax-efficient strategy, advisers must look beyond simply selling losers from Thanksgiving through Christmas. Instead of trying to cram tax-loss harvesting into the fourth quarter, it's far more effective to buy and sell strategically throughout the year.

That means advisers have to stay on top of the wash-sale rule, which prevents investors from recognizing a tax loss on a stock or security if they buy the same--or substantially identical--security within 30 days after the sale. The time limit therefore is either 31 days before, or 31 days after the stock or security is sold.

Advisers can avoid the wash-sale rule by buying the stock of a company in the same industry or buying a new mutual fund that holds securities similar to the stock or fund sold. Another method is to double up on the investment you want to sell for a 31-day period before selling the original shares. Alternatively, you can sell, then wait 31 days to repurchase the security. In effect, the investor will have booked a loss for tax purposes and subsequently reestablished the position, presumably at a more attractive price.

THE ETF CONFUSION

The exchange-traded fund (ETF) market has provided yet another way to avoid the wash-sale rule while maintaining a certain market exposure. But there has been some confusion regarding the use of ETFs to avoid the wash-sale rule.

The wash-sale rule prohibits investors from buying and selling "substantially identical" securities within 30 days. An ETF is only "identical" if it is the exact same fund. One can sell an small-cap index ETF and substitute another ETF that invests in the same type of securities at the same time. So, you can sell a Russell Mid-Cap Growth iShares ETF and buy a Morningstar Mid-Cap Growth iShares ETF without running afoul of the rule. As long as it comes from a different source and isn't called the same thing, even if it tracks the same market sector or style, it doesn't violate the wash-sale rule. The fact that the investment objectives of the two ETFs are the same is irrelevant, because they are not the same security.

Simultaneous transactions in mutual funds and ETFs can also be used in a substitution format. If a client owns a mutual fund with a substantial loss, he or she can sell it and simultaneously purchase an ETF.

An ETF can both be used to offset the gain from the sale of another ETF, and to offset gains from an actively managed mutual fund or an individual security. After selling a security to book a loss, the investor could buy a sector ETF that invests in the same industry as that stock and hold it for as long as the money is out of the stock. While the ETF may behave much like the stock, it is not substantially identical to it. Therefore, this maneuver wouldn't be considered a wash sale. Just be careful that you don't overpay brokerage commissions for such a quick transaction, especially if you are repurchasing the stock in 31 days. You may be able to work with your broker to get a deal on the three-way transaction involved in avoiding the wash-sale rule.

LOTS OF TAXES

The wash-sale rule makes it essential for a portfolio manager to maintain thorough records that document which specific lots of any security were purchased on which specific dates and at which individual tax-cost bases.

Using separate tax lots has other advantages over other cost accounting methods such as first in, first out (FIFO); last in, first out (LIFO) or averaging the cost of securities.

Keeping separate tax lots allows a manager to sell the highest-priced portion of a position--if the security had been purchased on multiple dates or had been received on multiple occasions as a gift, inheritance or from a corporate benefit plan. By selling the highest-cost-basis lots, the adviser creates the smallest gain. Most major portfolio management software will maintain tax lot figures automatically.

Maneuvering around the wash-sale rule in order to harvest tax losses and provide opportunities for security transactions with minimal tax consequences should be done within a client's portfolio on a regular basis. This way, advisers can insure that they have taken advantage of all opportunities to minimize taxes by engaging losses whenever necessary.

Tax-efficient investing is a necessary tool in managing taxable portfolios. For many investors, matching and harvesting tax gains and losses is the single most important way to reduce taxes now and in the future. It involves some trading activity, but also requires advisers to administer advice and counsel, and to be intimately aware of the client's tax situation across various investments.

When an adviser properly applies tax harvesting on a client's behalf, it can help save on taxes and diversify a portfolio in ways the client may never considered before.

Sidebar: Giving Away Your Tax Burden

Financial advisers and portfolio managers should also be aware of how annual gifting plays into the tax-loss harvesting strategy. It's important to look for new and inventive opportunities to donate appreciated securities.

For example, instead of contributing to the weekly basket at their place of worship, a client might consider an early-year donation of low-cost securities in an amount replicating the total annual cash donation. This creates a win-win situation all around. The charity would receive an early full contribution, for which it can budget. The investor/donor would receive a tax deduction and a reduction of a securities position that has a high embedded tax gain, and it would eliminate a weekly or monthly deposit to the collection plate. The adviser also has fewer shares of low cost/high gain stock to worry about.

Clients can also make gifts to friends and relatives. It's best to use high-basis securities so any sale by the recipient would generate the least amount of capital gains. Remember that the investor's original cost basis transfers to the non-charitable recipient.

If these securities are passed to a managed portfolio, the embedded capital gains can be passed to another family member--which is a significant tax-saving opportunity. This works best with gifts to children who are not subject to the "kiddie tax." Children who are 14 and older can sell property that has capital gains and pay taxes at rates as low as 5% (zero in 2008), depending on their income. Children under 14 pay taxes at the same rates (including capital gains) as their parents.

Advisers should also examine opportunities to reduce taxes through other non-trading techniques, such as donations to charitable trusts, which allow clients to benefit worthy causes. Investors who donate appreciated securities can enjoy two significant tax benefits: the income tax deduction for the donation and the deduction for the market value of the securities on the date of transfer. Furthermore, the donor is relieved of any imbedded capital gain burden when appreciated securities are contributed to a charitable trust. The investor, the organization receiving the ultimate trust capital, and the investment adviser all benefit from the creation and funding of such a trust. A final advantage is that it will be easier to manage the retained securities with a reduced burden of taxes.

Michael Provine is managing director for client relations at Tradition Capital Management LLC in Summit, N.J. He works with clients on trust and estate issues and is an attorney by training.

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