With stock indexes hitting new highs every few weeks, it might seem like an odd time to contemplate dealing with losses in a portfolio, but advisors shouldn’t ignore such losses, which if harvested, could reduce taxes.
“We harvest tax losses every December for sure,” says Roger C. Davis, chief executive at Woodridge Wealth Management in Santa Monica, California.
But the firm doesn’t just wait until the end of the year.
“We’re also constantly looking for opportunities throughout the year to harvest tax losses in client portfolios,” he says. “If you wait, you can miss great opportunities.”
Of course, if at year’s end a portfolio has losses, because positions were sold below the purchase price, those can reduce overall taxable gains, or if large enough, lower a client’s tax bill, easing the pain of a bad year. But real tax loss harvesting is actually a bit trickier.
The basic idea involves four steps.
If a company’s stock in a portfolio drops and is sold at a loss, the advisor finds a similar but not identical asset to buy as a placeholder to maintain the portfolio’s risk profile for 31 days. At the end of that period, the new shares are sold, and the original position is repurchased at the, hopefully, still lower basis.
A key is making sure that transaction costs for those four trades don’t exceed the benefits of the process.
Remember that tax loss harvesting should never be a goal. Building a portfolio is the goal.
Also keep in mind that loss harvesting is a method of deferring, not escaping taxes. As with an individual retirement account, Uncle Sam gets his cut eventually, though in theory, investors can invest the deferred funds until then.
Fortunately, the financial planning toolkits that most advisors use have tax loss harvesting software tools built in them these days.
Not all advisors who use these tools use put them on “full auto” or apply the rebalancing part, “though the adoption rate grows each year,” says Michael Kitces, a CFP and the director of wealth management and a partner at the Pinnacle Advisory Group in Columbia, Maryland.
Jeffrey Saut, chief investment strategist at Raymond James of St. Petersburg, Florida, agrees that tax loss harvesting can be beneficial, “depending on the portfolio and the companies in it.”
But he also suggests another approach: taking advantage of other investors’ use of tax harvesting to actually make money.
“If you’re astute, you’ll buy shares in companies that are being sold at year’s end by tax loss-harvesting investors, because since those sales are being made for tax purposes and not for fundamental reasons, you’ll typically see those shares pop at the start of the new year, offering portfolios that bought them a lift,” Saut says.
This story is part of a 30-30 series on navigating the growing world of choices for client portfolios