How investment portfolios are managed during a highly turbulent or down market greatly determines net total return once a rebound happens. This certainly applies to managing the level of risk — aiming for volatility that is tolerable while keeping a significant amount in assets with potentially higher returns, such as stocks. But it also applies to how well investment taxes are handled.
Especially during down markets, here at LNWM we pro-actively apply what is known as tax-loss harvesting to improve the returns on taxable client portfolios.
What is tax-loss harvesting? It is a way to benefit from a down market while staying invested to profit from the eventual rebound. There are two major steps:
Step 1: As we make tactical shifts in portfolio holdings, LNWM reviews opportunities to sell some positions at a loss. These losses can be used to offset gains realized earlier this year, as well as those realized later. Losses that cannot be used to reduce taxes in the current year can be carried forward into future years.
Step 2: We replace the investments sold with similar ones to maintain each portfolio’s targeted asset allocation and risk/ return attributes. Our goal is to keep clients invested in a diversified portfolio that can benefit from up moves in the market, while using tax-loss harvesting in the near term to increase future after-tax returns.
Watch Out for Wash Sale
When replacing securities, we are very careful to follow the IRS’ “wash sale” rule, so that any losses reported are not disqualified. The rule is basically this: you cannot claim a loss if you buy a “substantially identical” security (including through contracts or options) within 30 days — before and after – of selling at loss. This rule also applies to securities bought by your spouse or a company that you control, and to taxable (including joint accounts) and retirement accounts. A “gotcha” when selling part of a mutual fund is the automatic reinvestment of dividends, which can trigger a wash sale.
Your Big Picture
Ultimately, tax-loss harvesting works best when the transactions are aligned with each client’s entire asset base, tax situation, and cash flow needs. The following are things we consider carefully as we look for opportunities for tax-loss harvesting that will benefit each client across their entire asset base:
***Are there realized losses carried forward from previous years?
***What amount in realized gains and losses has the client’s LNWM portfolio generated this year?
***What other realized gains/losses are likely this year for the client – perhaps via sales of a business or property?
***Potential future gains – should we generate meaningful losses to carry forward that could be used to offset a significant gain in future years?
***Household taxable income – could generating additional losses move a client into a lower tax bracket for income and/or capital gains, potentially avoiding the 3.9% Net Investment Income tax, and minimizing exposure to higher Medicare Premiums (for those 65 and older)? Working with a client’s CPA if necessary, we can ascertain the various outcomes so the best decision can be made in context of current and future needs.
The Bottom Line
As trying as they may be, down markets provide opportunities — including tax-loss harvesting — to maximize net return during the current year and in the future. LNWM advisory teams routinely review our client portfolios and finances to see if and when tax-loss harvesting would be beneficial. And that’s especially the case now.