More On Tax Planningfrom The Advisor's Professional Library
- IRAs: Eligibility The eligibility rules for contributing to traditional and Roth IRAs are complicated. Learn how to effectively use them in retirement plans.
- Annuities: Estate Tax The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.
After the bull market of 2013, there is no question that many of your clients are sitting on a pile of capital gains, and likely a hefty tax bill, come April 15. Though there are only a few trading days left this year, there is still time to lower your client’s potential tax burden by loss harvesting. But how do you explain tax-loss harvesting to clients and let them know how they can benefit?
First, explain that tax-loss harvesting is merely a technique in which capital losses are realized to offset taxable gains and potentially reduce ordinary income by $3,000 a year.
As the calendar year draws to a close, advisors should have a good sense of their client’s tax liability. If a client has significant capital gains in a mutual fund, for instance, they may want to partner with their advisor to see if there are any loss positions that can be realized to mitigate the gains. Once a weak position is sold, the proceeds are usually placed in a proxy investment that has a similar investment outlook as the original fund. After a waiting period to avoid the wash-sale rule (see below), the money in the proxy may be returned to the original investment. Loss-harvesting trades can also be done in tandem with portfolio rebalancing or raising cash, so the use of a proxy investment may not be necessary.
The client’s gains and losses are netted out and the net gain becomes the client’s new tax liability. If capital losses exceed capital gains, up to $3,000 in losses can be deducted from the client’s ordinary income for that year. If losses remain, they can be carried forward in future tax years.
Avoiding a Wash Sale
Of course, Uncle Sam is wise to methods investors employ to lower and possibly erase their tax bill, so there are some rules to follow. If loss harvesting is done while raising cash or completely rebalancing, you likely do not have to worry too much about breaking the wash-sale rules. However, if the funds raised during a rebalancing trade are to be placed in a proxy investment, it is a good idea to double check your calendar to make sure you are not violating any wash-sale rules.
A wash sale occurs when an investor buys and sells a “substantially identical” security within a 30-day window. Put simply, if a client sold Fund A on Dec. 1, invested the proceeds on the same day into Proxy Fund B, and then sold Proxy Fund B to re-enter Fund A within 30 days, a wash sale would occur and the client would be liable for the full tax burden. (Not to mention the client would likely also suffer by facing multiple transaction costs.)
When doing loss-harvesting trades, remind your client that the wash-sale rule applies across the entire portfolio and not just a single account. Also, be mindful of how dividends are handled in the fund that is being sold. If you were only selling a weak lot in a position and not fully exiting the investment, any dividends that are reinvested in the original investment would violate the wash-sale rule. Finally, be sure to mark your calendar to remind you when it is appropriate to re-enter the client’s original position.
What Are the Risks?
In addition to making sure loss-harvesting trades avoid violation of the wash-sale rule, there are other issues to consider. We use proxy investments to ensure clients are still fully invested according to their investment policy statement while trying to lower their tax burden. However there are no guarantees in the investment world and it is important to remind clients of the short term investment risks posed by being in a proxy fund.
On the long-term end of the spectrum, it is generally not a good idea to harvest losses that greatly exceed gains for a given tax year. One year’s bull market can be met by years of a tepid or weak market meaning the losses could sit unused. There are also concerns about the future of tax rates and tax regulation that would erase the benefit of loss harvesting.
While tax-loss harvesting can be an excellent technique that will make April 15 much more palatable for your clients, it is important that you fully discuss the risks and benefits. Lowering tax liability is ideal, but be aware of its administrative and transactional costs to make sure it is fully appropriate for your client’s tax situation.