Make lemonade from lemons: tax-loss harvesting for HNW clients
Tax-loss harvesting, a common end-of-year practice at brokerages and advisory firms, can potentially reduce clients’ tax bill, but there are pitfalls.
With ever-escalating tax rates, financial advisors and other industry professionals generally agree on the value of tax-loss harvesting.
“Tax-loss harvesting is more valuable today compared to when tax rates were lower,” says Jim Holtzman, a certified financial planner, certified public accountant, wealth advisor and shareholder at Pittsburgh-based Legend Financial Advisors Inc.
Tax-loss harvesting typically involves the sale of a losing position and the purchase of a different security as a way of maintaining the bet and reaping future gains.
Ideally, these moves produce a tax-deductible loss and tax-deferred profits in the years ahead. Up to $3,000 of losses that exceed investment profits can be deducted against wages and ordinary income each year.
Unused losses carry over to future years and don’t expire.
Generally, clients of registered representatives and other users have standing orders with a brokerage firm specifically on which lots to sell and when to maximize the tax benefit.
“With gains, it’s best to hold the security for over a year,” says Larry Luxenberg, a CFP, managing partner and chief investment officer at Lexington Avenue Capital Management LLC in New York. “But with losses, there’s no need to wait.”
The big question is whether the strategy is best practiced at the end of the year or earlier throughout the year.
Gina Chironis, a CPA and chief executive of Clarity Wealth Management Inc., a registered investment advisor in Irvine, Calif., says that it is best to do planning earlier.
“The most efficient way for advisors to monitor client positions is throughout the year,” says Chironis, who is also a member of the American Institute of Certified Public Accountants’ personal finance planning executive committee.
One reason, she says, is that tax losses may be reversed by year-end, citing as an example recent market volatility stemming from China’s devaluation of the yuan.
Another reason not to wait is that the sale of a recently purchased mutual fund at year-end, for example, may trigger “non-qualified” treatment of the dividends from the investment, Chironis says.
In other words, if the fund is sold, dividends that would have been taxed at a lower capital gains rate might be taxed as ordinary income, reducing the benefit of the tax-loss harvesting strategy.
Although tax-loss harvesting can improve a client’s tax situation, there are drawbacks.
One is the Internal Revenue Service’s wash sale rule, under which the sale of a security means that the seller can’t buy back the security or one materially similar for 30 days.
In addition, advisors should encourage clients to establish a threshold amount before harvesting losses, Chironis says.
For example, a decline of 2% or more and/or a dollar amount of $5,000, can “make the cost of trading small relative to the benefit, she says.
In tax-loss harvesting, advisors stress that the investment should always be the primary consideration and the tax element is how to make lemonade out of lemons.
Bruce W. Fraser, a New York financial writer, is a contributor to Financial Advisor and On Wall Street magazines.