By Angie M. Stephenson, CPA, PFS, CFP
You often hear about tax efficiency being discussed related to investment portfolios. But how often do you hear the phrase “tax loss harvesting” used in relation to portfolio management? It’s a topic where the knowledge of CPAs can be very helpful to your clients.
Tax loss harvesting can be a valuable technique to achieve tax efficiency in your clients’ portfolios. Over a period of time, it allows an investor to reap tax benefits as the markets fluctuate or go through volatile periods. Using tax loss harvesting, clients can retain more potential future growth when the markets rebound.
Sometimes you will hear mention of tax loss harvesting at year-end or on an annual basis. However, based on how markets move and perform throughout the year, this minimal approach may not be the most beneficial. It does not fully consider the movements and changes in the stock market that occur throughout the year.
The year 2020 is a perfect example of how tax loss harvesting could have reduced taxes throughout the year. Regular tax loss harvesting throughout 2020 could have positioned accounts to keep more earnings and growth when the stock market improved, finishing the year from a positive standpoint. Waiting until December 2020 to look at the portfolio would not have provided many of the tax planning opportunities.
When markets fall, a tax-efficient plan has financial advisers looking for positions that may be in an unrealized loss situation. This is the start of identifying what positions may be good candidates to trade and recognize the capital losses. While the first step is to find positions that reflect unrealized capital losses, it is critical to have identified replacement investment positions. The replacement options should be similar to the investment being sold, while not running afoul of the IRS wash-sale rules.
The technique calls for selling an investment reflecting a capital loss while at the same time purchasing a replacement investment option that keeps the client account fully invested in a similar manner. The parallel choice allows the account to capture growth when the markets improve instead of keeping the proceeds in cash. This makes the portfolio tax efficient while not abandoning the economics of the allocations and long-term investment plan.
Here is an example.
On March 31, 2020, most equity indexes (stocks in the market) experienced a negative performance. You may remember the uncertainty when awareness of the coronavirus hit the world stage. But even with the shifting situation in March, these same indexes finished the year strong. They not only recovered, but also were in positive territory by Dec. 31.
||1/1/2020 through 3/31/2020
||1/1/2020 through 12/31/2020
|S&P 500 Index
|Russell 1000 Value Index
A financial adviser focused on being tax sensitive throughout the year will have considered the extreme market movement in March and taken advantage of that volatility.
Assume a client owned the following positions on March 31, 2020.
||Value at 3/31
|| Unrealized Loss
|T. Rowe Price U.S. Large
Cap Core Fund
|BlackRock Equity Dividend Fund
|iShares Core Small Cap ETF
|Total potential losses to realize
In this example, each of these investment positions would be sold to realize the loss of $30,000, which is reportable in the client’s 2020 income taxes. On the same day of the sale, replacement positions would be purchased that were similar to those sold – but, again, not exactly the same or you would run afoul of the IRS wash-sale rules.
Clients are allowed to take advantage of the dips in the markets by booking some temporary capital losses while rotating into other positions to maintain their long-term goal of keeping them fully invested in an allocation that is appropriate for their portfolio.
When the markets improved in 2020, clients captured the positive returns in the markets. Thus, booked realized capital losses in March could then be used against other capital gains realized in 2020. Note, it is not unusual to have a carryover of these capital losses to be used against gains in a future year for federal tax purposes.
Investing in a tax-efficient manner should consider the downward movements in the markets throughout the year to take advantage of these times with tax-loss harvesting where appropriate. Financial advisers and tax-savvy professionals who practice this will help their clients pay less in taxes while retaining more of their longer-term growth opportunities in their portfolios.
Angie M. Stephenson, CPA, PFS, CFP, is partner, chief operating officer, and senior wealth adviser for Domani Wealth in Lancaster, Pa. She can be reached at firstname.lastname@example.org.
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