It's getting closer: That loathed end-of-the-year tax season that causes many investors to scramble in search of cash to pay for an unexpected tax bill from the government. This year is shaping up to be a particularly high capital-gains tax year for mutual fund companies. By extension, this means potentially higher capital gains for investors, like your clients, who own those mutual funds. Adding insult to injury, many of these funds are still worth less today than when they were initially purchased, in spite of the general market advances we've enjoyed so far in 2003. Of course, that's not going to stop Uncle Sam from holding out his hand for his share of investors' "virtual" gains. Nobody said life was fair.
All investors will at some point be subjected to bear markets. If you have taught your clients well, however, they understand the nature of the markets and how they must tolerate the temporary downs in order to benefit from the permanent ups. Nevertheless, a loss is a loss, and temporary as it may be, it still leaves many investors with a sour taste in their mouths. Tax-loss harvesting is one way to turn these sour-lemon losses into much sweeter-tasting lemonade.
I used to cringe at the thought of contacting clients during bear markets. Not that I had anything to do with the dismal state of the stock market at the time, of course, but I just didn't enjoy being the bearer of bad news. These days, I like to focus on the silver lining that accompanies every bear market. My conversations with clients tend to go like this: "Although your portfolio has decreased X% in this last general market correction, this represents a terrific buying opportunity for dollar-cost averagers such as yourselves, Mr. and Mrs. Client. Furthermore, my recommendation is that we rebalance your portfolio and harvest some of your losses. The exercise could save you as much as 35% on a portion of your ordinary income tax for several years to come, and could potentially allow you to sell appreciated assets in the future without having to pay any taxes on your gains. Are you interested?" By this time, Mr. and Mrs. Client are listening intently while happily sipping their glass of freshly squeezed lemonade.
Properly executed, tax-loss harvesting allows an investor to capitalize on a downtrodden equity or mutual fund by selling at a loss and then using that loss to offset either realized capital gains or ordinary income up to $3,000. (For married couples filing separately, gains can offset as much as $1,500 of ordinary income.)
A good approach to tax-loss harvesting includes educating your client as to its merits and identifying one or more appropriate replacement investments. But it's even more important that you take steps to turn tax-loss harvesting into a year-round awareness, not simply a fourth-quarter exercise.
Teaching Your Clients
The first step in educating clients on the merits of tax-loss harvesting involves rewiring their brains' CPUs. For years, we have been programming them to understand the importance of long-term investing and how they should maintain--and even add to--their portfolios during down markets. To do an apparent about-face and recommend that clients should consider selling some of their holdings in a down market may seem counterintuitive to their way of thinking. The best way to reassure your clients that you haven't made an abrupt about-face is to explain the potential tax savings such a strategy can yield, while convincing them of a continued long-term focus.
Another misconception many investors might have stems from the old "But-it's-not-a-loss-until-I-sell-it" stigma. These investors don't want to face the fact that their money is gone and that the loss, albeit temporary, is a present reality. The challenge is in explaining that liquidating the devalued investment, and then immediately replacing it with a similar investment, leaves them essentially in the same position they were in before the sale (less the new realized loss and any transaction fees incurred, of course). Once they understand this proposition and see that this approach is an opportunity to have Uncle Sam share in the pain of their loss, the idea of selling becomes tantalizingly palatable to them.
Pick Replacements Carefully
So, how do you accomplish this? One option is for your client to buy back the same equity or mutual fund he or she intends to liquidate. Maybe it's a "good luck" stock or mutual fund that he or she just can't bear to part with for an extended period of time. Whatever the reason, we'll assume that the investor insists on reacquiring the position as soon as possible after it is liquidated.
Executing such a plan obviously assumes that there are no prohibitively costly transaction fees, such as mutual fund loads, that would be incurred while carrying out the sale and repurchase of the investment. Spending a considerable amount of money in transaction fees just to take a loss might not be very appealing to your clients. That may especially be the case if they are already carrying losses forward from previous years and now have more losses than they need to offset any gains.
The most important occurrence to watch for in this sale-buyback is a violation of the "wash sale rule." Simply stated, a wash sale occurs when a "substantially identical" security is purchased either within 30 days before or 30 days after the sale of the liquidated position. If a wash sale does occur, the loss will be added to the cost basis of the reacquired position, thus rendering the entire exercise futile.
Another consideration is determining what to do during the 30 days your client is left with a hole in his or her portfolio the size of the sold investment. Presumably, the asset sold made up an important part of a thoughtfully asset-allocated portfolio. Not replacing the asset with a similar equity or mutual fund during the 30-day wash period would be tantamount to abandoning the goal of having your client ride the Efficient Frontier of Modern Portfolio Theory.
To avoid being "out of the market" for that amount of time, you might recommend that your client purchase a highly correlated security and hold it for the 30-day period. Preference would be given to those securities having relatively low transaction costs, such as exchange traded funds, which we will discuss below.
A second tax-loss harvesting strategy involves buying a similar replacement investment and not buying back the original equity or mutual fund at the end of the 30-day period. This assumes that a suitable, highly correlated replacement investment is available, and that the client is willing to make it a more permanent fixture in his or her portfolio.
Replacing an existing investment can have benefits over and above that of enabling an investor to harvest a loss. Selling a mutual fund with a high expense ratio, and/or low tax efficiency, for instance, can yield additional annual savings for your client. To realize these savings, a good replacement investment may be exchange traded funds, or ETFs.
ETFs are passively managed, diversified baskets of stocks or bonds that trade as single stocks. Since they trade like stocks, ETFs offer low transaction costs and are highly liquid. Additionally, ETFs are very tax efficient, since, unlike mutual funds, ETFs tend to be less exposed to capital gains caused by investor outflows from a fund. The tax efficiency of ETFs is also inherent in the fact that there tends to be less portfolio turnover, and therefore fewer capital gains, than in many actively managed funds.
The wash sale rule should still be considered very carefully before making a swap with a replacement investment. One area of particular concern that is often overlooked has to do with selling one ETF and purchasing another, similar ETF as a replacement investment within 30 days. While performing a swap with two similar ETFs that track different indexes may not result in a wash sale, swapping ETFs that track the same index most likely will. The reason for this probable violation is that funds that track the same index generally hold the same securities, making the ETFs subject to the "substantially identical" prohibition. The Internal Revenue Service hasn't taken a position as to whether such a transaction is in violation of the wash sale rule, but perhaps that's because nobody has dared ask for one yet.
A Year-Round Endeavor
September is a big month for Ohio farmers who grow corn. They start up their tractors, drive them out of their barns, and harvest the fruits of their labor. Not every cornfield in Ohio is ready to be harvested in September, however. For that matter, the same cornfield might be ready for harvest in September one year, August the next, and October the year after that. Annual rain and sunshine levels, among other things, contribute to a farmer's decision regarding the ideal time to haul in his or her crop. So, too, should be your decision to harvest the losses in your clients' portfolios: those losses might be equally as dependent on environmental factors--economic environmental factors.
Many advisors think of harvesting the losses in their client accounts around the same time every year. It's usually around this time of year, in fact. But what makes the end of the year the best time to sell depressed securities in order to harvest a loss? Is it because securities are likely more depressed at the end of the year? Not necessarily. If the markets were that predicable, there would be a lot of people making a lot of money shorting stock in September, and collecting the proceeds in late December.
We make a point of telling our clients to buy on market dips. We tell them to think of these dips as huge "blue-light specials." Everything is on sale, so you had better fill your shopping cart to the brim. Why, then, do we not take the same approach when it comes to harvesting losses within a portfolio? In addition to telling clients to buy additional securities while they're "on sale," we should also recommend that they sell current positions in order to harvest some losses whenever market conditions, and personal economic conditions, make it prudent to do so.
Another reason to harvest losses throughout the year is to avoid the year-end rush you might experience trying to communicate with your client and execute the trades in a timely fashion. Most clients are thinking more about the upcoming holidays than figuring out whether they can part with their favorite tech stock. Year-round harvesting means looking for opportunities to take advantage of market downturns and executing the plan when the harvest is ripe, not when some arbitrary end-of-year period comes along.
One approach that lends itself to continual year-round harvesting is to own the individual sectors of a broad market index such as the Dow Jones U.S. Total Market Index. There are 10 sectors making up this index, including such widely held components as financial, healthcare, technology, and consumer cyclicals, to name just a few. These sectors can be purchased individually via ETFs offered by iShares, and held in proportions equal to that of the Dow Jones U.S. Total Market Index.
The advantage of holding the individual sectors as opposed to a total market index is that the investor will be able to not only take advantage of market declines, but also individual sector declines. Sectors tend to be highly cyclical in nature, with some being up and others down at any given time. When a sector declines, the client could sell the related sector ETF, harvest the loss, and immediately establish a replacement position. Again, watching out for the wash-sale rules means not buying an investment that is substantially identical to the sector fund your client just liquidated. A good investment that could allow your client to wait out the 30 days might be a position in the Dow Jones U.S. Total Market Index. Taking a position in this index would ensure your client isn't out of the market when a general market upswing comes along.
Whatever your strategy to take advantage of beaten-up equities or mutual funds, take a note from America's farmers and pluck when the harvest is ripe for picking. Also, don't worry if your clients have a capital loss carry-forward already. It never hurts to have large reserves of capital losses. You never know when the sun is going to shine over the markets and provide a bumper crop of capital gains.
I recently met with a couple who had become disenchanted with their previous advisor over the performance of their portfolio. I explained to them that the negative returns they had been experiencing over the past few years were mainly due to a general correction in the overall market, and that the previous advisor had actually done a fairly good job of allocating the assets in their portfolio. When I pointed out that some of the mutual funds could be replaced with similar, lower-cost ETFs or index funds, and that by harvesting some of their losses they could potentially reduce their income tax for several years to come, they were delighted. Knowing how to turn a negative situation into a positive situation can help secure clients for life. A previous advisor's loss due to his or her inability to make lemonade can be another advisor's gain.