1. October 13th, 2015
Frank Pape,
Director, Consulting
Services
6 ways many investors mess up tax-loss harvesting
The recent market volatility has many advisors reviewing client portfolios for opportunities to harvest or recognize any
possible losses. Given the low volatility across equity markets over the past 3+ years, there has been little opportunity for
productive tax-loss harvesting. Recent events have changed this. And even aside from market volatility, there's a certain
amount of volatility inherent in vehicles like stocks, bonds and mutual funds, which can be sources of tax-loss harvesting
, too.
Loss harvesting is the act of selling an asset that is lower in price than its original purchase price (adjusted cost basis).
This difference can be a loss that is "harvested" and used today or in the future to offset against gains. Creating this loss is
considered a tax asset and will help in deferring the recognition of gains (if you have them!) until later periods. Done
correctly, this deferral of gain recognition is intended to increase after-tax returns and help maximize after-tax wealth.
But, the process can be complicated. Below are 6 common mistakes investors often make, and where we believe
advisors can really make a difference when it comes to effective tax-loss harvesting.
1. First, be aware the strategy exists - and who might benefit most from it!
Taxable clients, for whom the goal is to maximize after-tax returns, may stand to gain from successful tax-
loss harvesting. For taxable clients, the pre-tax return shown in quarterly statements can have little bearing
on a client's ability to achieve their financial goals. It's the amount after-tax that will ultimately help these
investors get to where they are going. Productive tax-loss harvesting could make a big difference in
deferring gains and maximizing after-tax returns for taxable investors.
2. Overcoming the fear of selling a "loser."
Tax-loss harvesting forces investors to sell a security that has lost value - which is often hard to do because
it goes against the grain of investor optimism. When the goal is focused on trying to maximize after-tax
returns, this reluctance to sell needs to be overcome. However, the goal is not to just sell any security that
goes down, but to make that decision as part of a broader, thoughtful approach.
3. Only harvesting losses at year end.
Many investors focus on harvesting losses only at the end of the calendar year, as a last-ditch effort to
reduce their tax bill for the year. But, as the exhibit below shows, active loss harvesting is more rewarding
when opportunities are seized as they afford themselves - not just at year-end.
2. U.S. equity: Russell 1000® Index. Indexes are unmanaged and cannot be invested in directly. Returns represent
past performance, are not a guarantee of future performance, and are not indicative of any specific investment.
4. After harvesting the loss, being in cash for 31 days or choosing the wrong replacement security.
When you harvest a loss, you are selling a security. What to do with the cash proceeds from the sale?
Some investors choose to hold cash while waiting 31 days before repurchasing the original security to avoid
the wash sale rule. In a downward trending market, this may be a fine strategy. But generally advisors want
to keep the cash proceeds invested in the market - typically in a security with very similar characteristics as
the original security. If purchasing a replacement security, make sure it has similar characteristics (e.g. cap
size, style, industry, etc.) as the original holding - but is still "substantially different" (see #5 below). Also,
consider whether the client's asset allocation needs have changed? If not, avoid introducing any unintended
risks or deviations from your policy portfolio via the new security. At 31 days or later, consider reverting
back to the original security - if the investment rationale still holds.
5. Buying a similar security and having the loss disallowed.
When making the sale and purchasing a replacement security, make sure the replacement security is
"substantially different" in character. Some aspects to pay attention to include fund share class, benchmark,
security type, etc. The IRS can be very particular in regards to the new security being different in nature
than the original purchase. If the securities are too similar, the loss may be disallowed, causing the entire
effort to be of no avail.
6. Making sure the juice is worth the squeeze (understand the materiality).
This isn't a process you want to do every time a security goes down in value. Consider the size of the
portfolio, magnitude of the downturn and costs related to the trades. If your client is in the top tax bracket,
take the amount of loss harvested and multiply by 43.4% for short term gains (39.6% + 3.8% for net
investment income). That's how much you are creating in potential tax savings. Again, this only works if you
have current gains in the portfolio or can carry forward into future periods.
The bottom line
When investing in a security, there's always the hope that it will go up in value. But of course, that's not always how it
goes. It's a natural part of the investing process that some investments will rise while others fall in value. For taxable
accounts, tax-loss harvesting is a way to exploit these inevitable downturns and attempt to use them to set your client
up for an improved long-term, after-tax return.
Bear in mind, this process is not easy and requires a disciplined approach. At Russell Investments, our portfolio
management team, our systems and our processes are geared toward making tax-loss harvesting be a key strategy
within our tax-managed offerings - not only at year-end. And we make sure the juice is worth the squeeze!
The Russell 1000® Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell
3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index
