"You can't win for losing."
Growing up, I remember a friend’s mother who seemed to be the living embodiment of Murphy’s Law, using that expression to remark on her flat tires, lost jobs and failed relationships. To paraphrase the Ray Charles song, if it wasn’t for bad luck, this poor woman would have had no luck at all.
Happily, for clients whose investment results resemble this woman’s life, the U.S. tax code offers a break. When it comes to investments, you can win for losing. It is worthwhile for advisors to keep in mind that when they use a strategy known as tax-loss harvesting, losing investments can have a positive impact on a client’s bottom line. In a volatile market like today’s, portfolio losses have real value.
HOW IT WORKS
Here’s a review of how the harvest is reaped: When a client sells positions at a loss, the losses can first be used to offset the client’s gains for the current year. Even if the client does not have any gains to offset, up to $3,000 in losses can still be deducted from the client’s ordinary income. Since capital gains for most tax brackets are taxed at a lower rate than the corresponding ordinary income tax rates of 25%, 28%, 33% and 35%, the opportunity to offset ordinary income creates the potential for even greater tax savings than if the client simply had $3,000 of gains to offset. (The exceptions are the top income tax bracket, 39.6%, which has a 20% tax on capital gains, and the lowest two brackets of 10% and 15%, which pay no tax on capital gains.)
Beyond that, any losses that exceed the client’s gains for the year, plus $3,000 in ordinary income, can be carried over and used to offset capital gains the following year and the year after that, and the one after that into perpetuity if the losses are great enough.
Carried-forward losses don’t expire until death; then, unfortunately, the client cannot pass them to his heirs.
There is a caveat, however. The IRS’ washsale rule prohibits a taxpayer from claiming a loss on the sale of an investment if he or she buys the same or a substantially identical investment within 30 days of the sale date.
But even here there’s a workaround. After harvesting a tax loss, rather than sitting on the cash from the sale proceeds and waiting 30 days to buy back the security you just sold, you can invest in a tax swap, acquiring a similar but not substantially identical security, to keep your client exposed to the asset class.
The tax swap functions as a 30–day placeholder to avoid running afoul of the washsale rule. Once the 30 days are up, you can switch back to your original holding — or you can stay invested in the comparable security.
Here are a few worthwhile tips to consider as you harvest:
• Take the long view. It can be beneficial to consider what the client’s capital gains rate is today versus what it could be in the future. There are now effectively five capital gains rates: zero, 15%, 18.8%, 20% and 23.8% (due to the additional 3.8% Medicare surtax added for individuals and couples with adjusted gross income of more than $200,000 and $250,000, respectively).
Given this wide range, there’s a chance a client’s rate could fall from what it is now and the amount of tax savings could grow through an effective tax arbitrage.
This is where the full benefit of harvesting is realized. Ideally, you’d harvest a loss, reinvest the sale proceeds and the client would have a lower capital gains tax by the time you sell the appreciated security.
Capital losses offset capital gains before they are allowed as a deduction against ordinary income. So, let’s say you have $6,000 in capital losses and $4,000 in capital gains. The first $4,000 in losses offsets the gains, leaving $2,000 to deduct against ordinary income. But remember, harvesting works even in years when there are no gains to offset, so consistent harvesting can create real value over time.
• Invest the tax savings. Here’s an example from Schwab that I often share with clients: “In a combined marginal bracket of 30%, just taking advantage of the annual $3,000 capital loss limit against ordinary income means an extra $900 per year in your pocket (less commissions, if any). Assuming an average annual return of 8%, reinvesting $900 each year would amount to an extra $41,185 after 20 years. That would more than offset the additional capital gain tax should you end up selling the replacement securities with their lowered cost basis. In fact, if you donate shares to charity or bequeath shares to heirs who receive a step-up in basis, the tax savings from loss harvesting would be permanent.”
• Don’t harvest just to harvest. A small loss means a small tax savings that can be devoured by transaction costs, so a good rule of thumb is not to harvest losses less than a few thousand dollars. And, speaking of costs, take a look at the cost of the tax swap, especially if you plan on holding it longer than 30 days. You don’t want to replace a low-cost investment choice with a much more expensive one. Finally, because your reinvested tax savings can grow over time, harvest in accounts that clients intend to hold more than a year.
• Harvest year in and year out. Especially in volatile markets, don’t wait until December to harvest losses; harvest as the losses occur. During periods of volatility, selling to harvest losses gives us opportunities to tweak portfolio exposure, taking a more defensive stance in some markets and reducing client exposure to others.
• Harvest to manage emotions. A recent Wealthfront blog post observed that, based on anecdotal feedback from their clients, there could be a “behavioral benefit” to taxloss harvesting. According to Wealthfront: “When markets pull back, investors have a natural tendency to want to do … something."
Investors who worried about their portfolios in Q3 were able to log in to their accounts and see exactly what was happening inside. They saw that our service had a plan for how to cope with market pullbacks and that it was executing on that plan, selling certain securities and buying others. You could see each sale as it took place, and the total amount of losses harvested as a result. The engagement provided useful activity … without harmful behavior like selling out at the low.”
While most advisors will not be able to provide that kind of a window into their harvesting activity, it is interesting to view harvesting as Wealthfront does — as a strategy that scratches an itch that clients often
get when markets take a dive and they feel the need to respond.
Tax-loss harvesting can be an effective strategy, one that makes lemonade out of lemons to add tax alpha. But it requires diligence and forethought to squeeze out the most value for your clients.
Kimberly Foss, CFP, CPWA, is a Financial Planning columnist and the founder and president of Empyrion Wealth Management in Roseville, Calif., and New York. Follow her on Twitter at @KimberlyFossCFP.
Register or login for access to this item and much more
All Financial Planning content is archived after seven days.
Community members receive:
- All recent and archived articles
- Conference offers and updates
- A full menu of enewsletter options
- Web seminars, white papers, ebooks
Already have an account? Log In
Don't have an account? Register for Free Unlimited Access