Taking an active approach to investment tax management is one of the best ways to consistently add value to your clients’ portfolios. Any outperformance realized is known as tax alpha—a portfolio’s excess return after taxes minus its excess pretax return.
The tax alpha edge can be highly valuable. In fact, according to a 2019 Envestnet | PMC study, effective tax management can add 1 percent to a portfolio annually—and potentially more in highly volatile years. It can extract a positive result from a market downturn and demonstrate a clearly quantified value to clients with investment losses.
Generally, using tax-efficient products and holding inefficient assets in tax-deferred accounts are good strategies for creating tax alpha. But, to really boost returns, it might be wise to regularly practice tax-loss harvesting, a tactic called “the only sure alpha that I know of” by the esteemed economist Burton Malkiel. Below, I’ll review the what, when, and how of this important tax-management strategy.
Simply put, tax-loss harvesting is the practice of selling off losing assets or positions. By taking losses instead of holding them on paper, you can use them to offset portfolio gains or a portion of ordinary income. Of course, you’d never set out to buy high and sell low, but we all know that most diversified portfolios will have some depreciated positions. Taking instead of holding these losses can allow a client to delay paying taxes and attain more tax-deferred growth on the retained earnings.
Most advisors implement tax-loss harvesting at year-end. They review the gains realized by selling portfolio winners over the course of the year and look for losses to offset them. Although this timing can be effective, handling losses throughout the year can yield greater results. Market downturns often create the best harvesting opportunities, and they can happen at any time. By developing and maintaining a repeatable process in your playbook, you can address it when the opportunity arises.
Without being able to predict a market downturn, some advisors look for tax-loss harvesting opportunities on a periodic basis, such as quarterly, semiannually, or annually. No matter how often you decide to conduct reviews, there are two ways to go about it:
- Identify a list of nonqualified accounts you would like to review individually. This could be a list of the largest households or accounts that deserve special attention on a position-by-position basis.
- Look at the holdings across your business. What are the largest overall positions, and how have they performed recently? In aggregate, what are the unrealized gains or losses on a particular position?
Once positions have been identified as candidates for harvesting, confirm that no purchases of the security have been made in any accounts in the past 30 days, including retirement accounts. (Losses from a dividend reinvestment will be disallowed, but it may be a small amount that won’t derail the overall strategy.) Then, decide whether you want to keep the proceeds in cash or invest them in a replacement security for the next 30 days. It’s generally advisable to use a replacement security to maintain market exposure and avoid the potential pitfalls of market timing and missing out on a rebound over the next month. When doing so, however, be aware of wash sales.
According to the IRS, a wash sale occurs when you sell or trade securities at a loss and, within 30 days before or after the sale, do one of the following:
- Buy substantially identical securities
- Acquire substantially identical securities in a fully taxable trade
- Acquire a contract or option to buy substantially identical securities
The IRS created this rule to keep investors from reaping tax savings without materially changing their economic position. The concept is quite simple, but the implementation is far from it. Because wash sales effectively disallow the losses generated through tax-loss harvesting, you need to be careful if you choose to use replacement securities.
The IRS is vague, leaving it up to investors to “consider all the facts and circumstances in your particular case” (IRS Publication 550) to determine if a position is substantially identical. As you weigh available choices, keep the following guidelines in mind:
If you sell an ETF or index fund, you can replace it with a product that tracks a different index. But be aware that:
- Replacing one S&P 500 fund with another is generally considered running afoul of the intent of the IRS.
- Swapping one security for a different one that holds the same 500 companies in nearly identical weighting does not put you in a different economic position, so you should seek another option.
Actively managed funds are usually considered safe territory, despite commonly overlapping positions.
Although tax-loss harvesting can be a challenging process to scale, it gives you the ability to take advantage of down markets. Having a defined strategy in place can set you up for swift and successful implementation, especially during times of heavy client outreach due to market volatility. Your process might include periodic reviews, researching replacement securities for your top holdings in advance, and identifying key relationships that could benefit from this value-added service. All in all, the mastery of tax-loss harvesting is a useful tool for delivering tax alpha throughout all market cycles.
Have you found that tax alpha provides significant value to your clients? Do you have any tips for streamlining the tax-loss harvesting process? Please share your thoughts in the comments box below.