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Financial Planning > Tax Planning > Tax Loss Harvesting

Double Whammy

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It’s dismal enough paying taxes when the economy is vigorous and sane. Doing so in yet another year when some portfolios are down 40% to 60% “really ticks clients off,” as one planner puts it. Worse, this double whammy has more than one advisor-client on the edge of his risk-tolerance seat with a finger on the sellout button. The trick for planners is not only to assuage their charges’ fears by praising the wonders of diversification, but to show clients that their losses can be manna from tax hell–and then make it happen.

While a judicious review of client portfolios can yield opportunities for the implementation of effective tax-saving strategies, with a watchful eye toward surprisingly common pitfalls (which we will examine below), many planners maintain that harvesting losses this tax year is the key to it all. Advisor Bruce Primeau is one such believer who knows the concept isn’t always easy to convey. “Initially, it’s hard for clients, even CPAs, to see,” says the former CPA who “did time in public accounting” and who now is director of Wealth Management Services at Wade Financial Group in Minneapolis, Minnesota, a fee-only firm that focuses on small business owners. “You’re working these losses, you’re making these moves, and they’re saying, ‘Okay, but where’s the pot of gold at the end of the rainbow?’”

Believing there is no pot, some clients rush to stash their money in cash, in money market instruments, not realizing that by moving themselves out of a capital-gains tax treatment context they are subjecting themselves to ordinary income gain treatment. “By making that move they are automatically giving themselves a tax increase,” says Primeau. “You sell stocks and bonds–they have long-term treatment–you get the 20% rate; any interest income that you get is taxed at the ordinary rate; so if you’re in the 40% tax bracket, you just lost 40%.” He cautions clients against making tactical moves over strategic moves, and warns that attempting to time the market is a fool’s errand indeed.

Tax strategies deployed on behalf of a client are in considerable measure dependent ultimately upon the client’s financial personality. For example, experience has shown Wade Financial that its clients fall into three general areas, areas undoubtedly applicable for advisor clients everywhere. Clients in Group A are those not as concerned about the market as the average man on the street (they let their advisors do the worrying for them). Primeau explains that the recommended strategy for Group A clients is to “hang tight” and stick to their long-term investment horizon. Group B clients comprise those who are “somewhat” concerned. For these clients, Primeau is not against them making a 20% move down in equities, say from 60% to 40%. Group C are those persons “overwhelmingly concerned” (Wade Financial has had few of those, Primeau concedes), and who wish to make a 40% or greater shift towards bonds. Such clients are immediately called into conference.

The Big Picture

Being right when it comes to tax planning can be challenging. Most independent financial advisors outsource their client tax preparation needs, though there are exceptions. Pat Konetzny of The Practical Advisor in Maynard, Massachusetts, prepares the majority of her clients’ taxes, as do most of the other advisors in the Alliance of Cambridge Advisors, a network of personal financial advisors, of which Konetzny is a member. Tom Orecchio ,of the wealth management firm Greenbaum and Orecchio in Oradell, New Jersey, outsources his client tax preparation and works closely as the “financial quarterback” with the client’s accountant “to get it right.”

Communication is vital, Orecchio says, because while the planner doesn’t always see the big picture from a tax perspective, the accountant does. For example, a client may incur capital gains from something outside his investment portfolio. “We’ll go back to the accountant and say, hey, is there anything that is unique about the client’s tax situation this year that might impact the way we manage the portfolio? And we let the accountant make that decision,” says Orecchio. With the exception of the past few years, Orecchio has rarely received a call from a client’s accountant regarding investment performance issues. Now the phone is ringing more often.

The phenomenon from the accounting perspective is of special interest. Ginger Broderick, a CPA who runs a small accounting business in New York that specializes in fine art and taxes and occasionally writes for Investment Advisor, agrees that there is much more interaction between accountant and planner. “I probably talk to my planner a couple times a week and run through our client base,” she says. “He gives me an update on anybody that called him, and on areas of concern that we might have.” It is to the planner’s benefit that he work more closely with her, Broderick adds, because she is then more likely to refer him to her clients.

Ongoing communication between advisor and client in regard to tax matters is vital, too. For the past two years Orecchio’s firm has sent to clients a special report detailing anticipated capital gains from their mutual funds, showing how those anticipated gains will affect each client specifically. “The report looks at a very client-specific issue,” he says. “Rather than just saying this fund’s going to pay out 30 cents a share, we show them exactly what it means to them. And with that anticipated report, and with their unrealized gains and loss report, they could do offsetting trades, or make [other] tax-motivated trades. We’ll work with the accountant and the client to figure out how to reduce the taxable bite.”

Curt Weil, of Weil Capital Management in Palo Alto, California, has clients sign a letter of permission that allows Weil to discuss his clients’ financial affairs with all concerned parties, “something we do regularly,” he says. Primeau notes that for the past several years Wade Financial has had in place a year-around service for tax planning–not tax preparation, which is jobbed out. “It’s designed to help small business owners or people who have high income year after year, who have paid taxes through the nose, and who don’t have a clue on how to shelter some of it,” he says. Their accountants often don’t either.

Like Orecchio, Primeau looks at the “big picture” with an eye toward tax control, something that tax preparers aren’t necessarily prepared to do, he says. As noted, Primeau is himself a CPA, as is the firm’s manager of tax planning services. “Nothing against CPAs, but we’re not great forward-lookers,” Primeau says. “We’re great at preparing taxes, we’re not great at tax planning. By preparing a tax return, how do you add value? You don’t. It’s historical. You’re reporting. You’ve got to go beyond that.” Since leaving his work as an accountant to become an advisor he’s found himself taking “more of a look from the top, getting under the hood, so to speak, to see what opportunities exist for a given client–and doing much more work up front.” Primeau gives this simple but common example: a client comes to him showing a $300,000 W-2, with lifestyle spending of $100,000–and yet he’s paying a 39% ordinary income tax rate. At a meeting with the client and tax preparer, Primeau will suggest putting a portion of the unspent money into some type of deferred vehicle through the client’s business, in order to save taxes and plan for the client’s retirement.

Time to Recharacterize

Tinkering with Roth IRAs is a common tax strategy this year. Like many advisors, Weil combs through client portfolios to see if it makes sense to “recharacterize” their existing Roth accounts. Here’s how it works. Let’s say that in 1998, the year the IRS bestowed upon investors the option to pay their tax bills over four years, a client converted a sizable IRA to a Roth IRA. Assuming the client was on a tax return extension, he had until August to perform this recharacterization–an IRS term meaning, in effect, to reverse the conversion. Let’s give that 1998 conversion of an IRA to a Roth IRA a value of $500,000. Because of the bear market, today that Roth is down 30%, to $350,000. But also today, if the client recharacterizes, he can get back all the tax money he paid out on the $500,000 value, wait 30 days, and convert the account again at the lower rate. How much lower? Assuming the client was in, say, the 31% federal bracket when he converted, his tax cost was about $150,000 over four years. By recharacterizing, he gets back the $150,000. Thirty days later he can “Roth-ify” the IRA again, and his tax bill will be $105,000. In rough numbers the client saves about $45,000. “Nice move, isn’t it?” asks Weil. He adds that, unfortunately, his accounts on average are up 8.5% from December of 1998, thanks to the strict adherence of a diversified-by asset-class strategy.

Sometimes, however, it makes good tax sense to close a Roth IRA account, especially if the investor owned Enron or similar equities that are worthless or nearly so, and the account itself becomes worthless. The tax angle is to sell out and grab whatever assets are left, and take a tax loss as a miscellaneous deduction, subject to the 2% floor in miscellaneous deductions. But it’s not always that simple, cautions Alan Weiner, a CPA as well as a J.D., L.L.M., senior tax partner at Holtz Rubenstein & Co. in Melville, New York, and occasional Investment Advisor tax columnist. Myriad factors are at play, all arising from the uniqueness of each client’s financial situation, making generalities about the advisability of selling out of Roths imprudent. That said, it’s safe to say there can be negative tax ramifications if the investor hasn’t had the account for five years, and that if the taxpayer is subject to the alternative minimum tax (AMT), that miscellaneous deduction won’t do him any good at all. Accepting the viability of closing a Roth, it is vital that the taxpayer, whether he set up a Roth IRA or converted a traditional IRA to a Roth IRA, knows what his tax basis is. This may sounds obvious, but Weiner says that’s not often the case. “I don’t think taxpayers are aware,” he says. “I don’t think anybody ever expects to close these things and take losses, so I’m sure nobody’s keeping track of their basis.”

When it comes to money and taxes, there is much that is not obvious. Primeau finds it necessary to keep reminding his more short-sighted clients that for the better part of the past decade they were realizing capital gains, whether from stock sales or mutual funds, with no way to offset those gains due to a runaway bull market. Primeau will tell clients: Now you can use market loss as an anecdote to gain. Plan to sell your dental practice in order to retire? Guess what? That sale is a capital gain. Got this rental property that you’re looking to get out of? That rental property, fully depreciated, is a capital gain. Primeau believes an advisor can never do enough coaching with clients, especially those with an inflexible mindset. “What do you do with those capital gains?” he’ll ask rhetorically. Well, here’s what you’ll do with them in the absence of loss on your tax return: you’ll pay taxes on them. Says Primeau: “We’re trying to find ways to get creative in using these losses versus just plunking down the allowable $3,000 [deduction] each year and hoping we and the client live long enough to use all his capital losses.”


Getting creative with mutual funds that have tanked is high on advisor Weil’s agenda this tax year, the result of a client-portfolio tax-review process that was underway in his office by mid-July. When appropriate, he’s been busy switching clients out of some funds and into other similar funds with embedded tax-loss carry-forwards. What clients get with this is “twice the bang” for their lost bucks, Weil says.

In explaining to clients how the tax-loss carry-over procedure works, he makes sure they first appreciate that part of the tax code that dictates that mutual funds, and therefore the mutual fund companies that offer them, must distribute at least 95% of any realized gains, along with interest or dividends, in order to avoid being taxed. “This is why a lot of people were irritated in the year 2000,” Weil says. “They bought funds that finished down substantially but still got hit with a capital gains distribution.” Today, if a client’s fund has a realized capital loss, the only thing he usually can do is warehouse it until he has gains to offset it. In other words, investors have to distribute the gains that they’ve realized but can’t distribute the losses they’ve realized.

There’s a simple solution: switch funds. Weil uses the example of a client invested in the Vanguard S&P 500 Index fund (VFINX), which is down 21% so far this year alone (as of September 13) after losses of 9% in 2000 and 12% in 2001. Weil sells the fund, enabling the client to use the loss to offset capital gains dollar for dollar, with no limit. (Any excess can be applied to up to $3,000 of ordinary income. Any leftover loss can be carried forward indefinitely, terminating upon death.) The real question, relative to Weil’s illustration, is what is done with the money taken out of the Vanguard 500 fund? “As an example, we’ll buy an index fund,” he says, “such as Nations Large Cap Index/Primary A (NINDX), which has a 31% capital loss carry-forward. So not only does the client realize the loss on the existing Vanguard position for this tax year, but the next 31% of gains in that fund (assuming Large Cap comes back sometime in the near future) will be tax free, since the fund can only use the capital-loss carry-forward to shelter capital gains in the future.”

The wash-sale rule doesn’t pose a problem to the fund-switching strategy either, as long as the same securities are not sold and repurchased. (See the Tax Advisor on page 61 for further treatment of how to harvest tax losses.)

The AMT Trap

According to Ron Sanchez, head of Municipal Fixed Income Group at Fiduciary Trust, the Alternative Minimum Tax (AMT) will by 2005 affect anywhere from 13 million to 20 million taxpayers. “I’ve read reports where middle income earners [meaning those with incomes of more than $125,000], will conceivably be paying AMT,” says Sanchez. And they probably don’t know they’re at risk.

Designed to keep the rich from living tax-free, the AMT sought to capture tax dollars from an estimated 2% of the population. For these few wealthy, a second and separate tax calculation was required. But inflation and the fact that the AMT has never been indexed for inflation–unlike regular tax calculations–have broadened its application. With no adjustments to the alternative minimum thresholds, the base rate extant in 1986 still applies.

Sanchez, a 15-year financial services veteran, says he doesn’t remember the last time he sat in front of somebody who was not subject to the AMT, while fewer than 10 years ago, the subject rarely came up.

Here’s a simplified overview of how the AMT works in relation to the regular tax calculation, and what makes one subject to AMT. All taxpayers perform a regular tax calculation to determine a given tax liability. The separate AMT calculation disallows certain deductions and includes certain items on the income side that are not included in the regular tax calculation. “Essentially the IRS is trying to include more income and disallow certain deductions, which then inevitably will raise your adjusted gross income relative to the regular tax calculations,” explains Sanchez. What this means is that “all things being equal” and in terms of AGI, an individual’s tax calculation is higher under the AMT than under the regular tax calculation. “Then you apply the AMT, which is one threshold, either 26% or 28%. So the AMT rate is lower, but it’s generally on a higher AGI,” says Sanchez. After performing the regular tax calculation and the AMT calculation, the taxpayer will pay whichever tax liability is the higher of the two. If under the AMT calculation the tax liability is higher, then the taxpayer is known as an AMT taxpayer, who is paying higher taxes, not in terms of the absolute rate, but in the amount.

As noted, for a certain level of income a given taxpayer will be in a lower tax bracket under the regular tax calculation, as compared to the “inflexible” AMT calculation, due simply to indexing or inflation adjustments made by the IRS. The situation has been exacerbated by tax legislation that saw the highest regular tax rate drop last year to 39.6%, to 38.6% this year, will see it at 37.6% next year, and down to 35.6% by 2005. The danger, says Sanchez, is that everyone thinks they’re paying lower taxes, but not if they are subject to the AMT.

What can the AMT taxpayer do? First, accept the fact and “make modifications to your fixed income portfolio to better ease the burden of AMT,” advises Sanchez. “Or better yet, raise your income.” The after-tax process at Fiduciary acknowledges that for a certain level of income, the marginal tax bracket is not 38.6% but 28%. And at a 28% tax bracket, the conclusion is not necessarily finding tax-free municipal bonds–the normal response, and an obvious mistake for most AMT taxpayers who load up on them, since most taxpayers need tax-exempt income. An AMT taxpayer, says Sanchez, learns that the tax hurdle of 28% is not particularly onerous. “There are opportunities to buy pre-tax income [instruments], pay the 28% tax, and on an after-tax basis yield more than tax-exempt securities.”

He advocates exploring the entire fixed-income spectrum–”not saying this is pre-tax or after-tax, but looking at all sectors, including, of course, tax exempts or munis.” Next, after-tax all sectors, and determine which sector offers the best after-tax yield. Then, study and after-tax the pre-tax sectors. How is their performace relative to the tax-exempt muni benchmark? Can you add some incremental yield pickup? From a yield perspective, there are times when that relationship between after-tax and pre-tax is quite volatile, notes Sanchez, and there are yield curve shifts and a number of other marketplace dynamics that can cause disparities between the tax-exempt instruments and Treasury instruments or any taxable instruments.

Given yield parity–meaning there is virtually no difference between buying a taxable investment (and paying the tax) and buying a tax-free investment–the AMT taxpayer still may opt for the taxable sector because it potentially offers superior performance going forward, or lower risk, or a number of other attributes that may result in an investment professional concluding that the pre-tax has better risk/return characteristics on an after-tax basis. “So this after-tax or optimization process, as we refer to it, becomes very important,” he says, in terms of constructing a portfolio.

Private activity bonds, known also as AMT bonds, can add value to a client portfolio–advisor Weil says he sometimes makes good use of them–though in general they are ignored. Private activity bonds are either tax exempt or taxable; they look like a municipal, and their yield can be attractive, thanks to a potential tax consequence. When included in regular tax calculations they are tax-free, but when part of AMT calculations they are not. If someone has a tax-exempt portfolio structured with no private activity bonds, the bonds are not taxed. “If someone has a tax-exempt portfolio that has 20% in private activity muni bonds, it’s possible that they are subject to a 28% tax rate on that, and it’s not tax-free,” explains Sanchez. The trap here is that some mutual funds tend to buy private activity bonds because of their higher yield. That’s fine as long as a fund shareholder isn’t an AMT taxpayer.

Despite the fact that the AMT has clearly gone far beyond its original mandate and there is considerable outcry against it, Sanchez sees no likely change to the legislation, due in large part to the huge cost the government would incur for modifications. “Maybe in 2005, when everyone says, What the hell is this AMT thing?” Sanchez quips.

Other Useful Strategies

Advisors are busy reviewing client portfolios and re-examining their tax returns with an eye toward tax-exempt holdings–which brings us back to bonds. Weil, when appropriate, is redeploying cash reserves to two- and three-year bonds. He recently sold a tax-exempt money market fund, which was yielding about 1%, and bought a University of California 5.25% triple-A issue bond that is callable in September 2003 and due on September 1, 2013. The yield-to-call is 2.75%, but because the coupon on 10-year bonds today is much lower, Weil figures it unlikely that the bond will be called. Assuming this is the case, the bond’s yield to maturity is 4.63%. By contrast, the yield to maturity of the 10-year Treasury is 4.2%. “So even if it doesn’t get called, I’m better off than if I were in Treasuries,” Weil reasons. “And it’s tax free, state and federal. Not bad!”

If there’s one subject that makes clients flinch, it’s their 401(k)s. With accounts creamed over the past several years, advisors are trying to breathe life back into them. The government is helping, too. President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001, which included changes to qualified 401(k) plan and simple IRAs. The $10,500 limit on individual contributions will be increased to $15,000 over a five year period, beginning with a $500 increase in 2002, and $1,000 per year for the next four years. Additionally, there is a 401(k) “catch-up” contribution for participants who are 50 years of age and older. The participants will be allowed to make an additional contribution to the 401(k) plan/IRA as follows: 2002, $1,000; 2003, $2,000; 2004, $3,000; 2005, $4,000; and 2006 on, $5,000.

Weil, for one, is working with clients to find ways to redesign existing plans, and if possible, infuse them with more cash. “We’re saying, all right, let’s exploit that. Let’s find more ways to get more money in there.” To do this he must convince clients that down markets afford them an opportunity to buy, not to stick conservatively with what they already have.

A hot topic for CPA Ginger Broderick’s clients, many of whom own rental property as investments, is turning those rental properties into personal properties. She cites as an example a New York client couple who live in a rent-stabilized apartment in Manhattan and own a rental property in Queens. Broderick is working on projections wherein the couple transfer their residency from Manhattan to the apartment in Queens. By living in Queens for two years–thus legally establishing Queens as their principal residence–should they then sell the apartment at a gain, that gain is tax free. “If it’s a $50,000 or $60,000 gain, that’s free money, and these are people that maybe have AGIs of $200,000 or $250,000,” says Broderick.

Another “housing” angle that Broderick pursues involves clients who live in rent-stabilized apartments that are in danger of becoming destabilized. Under current law, if the apartment qualifies as a luxury apartment and the tenants enjoy earned income in excess of $175,000, they will be charged the market rent. Broderick’s solution is to help client tenants transform their apartment buildings into cooperative buildings.

“It’s a tough time to be in this business,” maintains Bruce Primeau. “On the other hand, it’s an advantageous time” as well. Investors have shot themselves in the foot thinking they can be self-directors, he says. Five years ago they were throwing cash against the wall and were making money hand over fist. “Now they’re coming in here saying they turned $300,000 into $1.2 million and back to $300,000, and that it just isn’t fun any more,” he says. Clearly, investors need advisors. And those advisors with tax knowhow will be that much further ahead of the game.