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.
