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Financial Planning > Tax Planning > Tax Loss Harvesting

Replacing Stocks

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If the government won’t give you a tax break, then create one for yourself. This is a philosophy I believe more financial advisors and their clients should have. No, I’m not advocating that you break the law by underreporting your taxes. And no, you don’t have to go out of your way to save on taxes by establishing one of those complicated offshore trusts. In fact, smart tax planning is often a matter of good organization, following a few simple steps and using the right financial products to manage portfolios.

How much of an impact do taxes have upon your client’s returns?

According to Lipper, buy-and-hold mutual fund investors forfeited a stunning $33.8 billion in 2007. This number easily exceeds the previous record of $31 billion in the year 2000. What does it mean? It plainly illustrates that many mutual fund investors are still fairly ignorant about the tax ramifications of their investment decisions.

To understand the type of financial damage people are incurring, all you have to do is to look at the long-term impact of taxes on performance. Over the past 10 years, Lipper estimates that stock mutual fund owners had between 1.3 percent to 2.2 percent of annual returns confiscated by taxes. The obvious solution isn’t for your clients to bury their heads in the sand or to look the other way. Rather, it’s to construct their portfolios with tax-efficient vehicles like ETFs.

One overlooked aspect of tax planning is knowing when to realize capital gains and losses. In that regard, right now might be an ideal time to pay the tax on winners. In an election year, it’s especially difficult to accurately predict what future tax rates will be. I won’t try to make such predictions and neither should you. But regardless of who becomes president, paying higher taxes is almost a sure bet. “The assumption a taxpayer might desire to take at this time is that present tax rates are comparatively accommodative; whereas, they may not be in the future,” states R. David Telling Jr., an advisor with Telling & Company in The Woodlands, Texas.

Finding Alternatives Letting go of losing stocks or subpar performing funds is an emotionally difficult decision for many investors. It’s especially challenging if your clients inherited the investment from a deceased relative or by way of a long career at a particular company. What if they own a poorly performing stock that’s lost money?

Individual stocks that have been crushed are easy to locate. Just look at some of the worst performing industry sectors like financials, technology and Asian stocks. In each one of these equity categories, candidates for tax-loss selling abound. Remember, too, that capital losses can be deducted in the amount of $3,000 from your clients’ taxable income. Losses that exceed this amount, which many people unfortunately have, can be carried forward into the following years.

Anyway, Figure 1 can help you to mix and match widely held stocks with funds that share the same characteristics. My list could have easily included more stocks, but rather than overwhelm you with data I want you to understand my point. In this table, I’ve listed 10 widely held blue chip stocks. (Incidentally, I maintain a similar list of 100 stocks with their ETF substitutes and my list continues to grow each day. I’ve got another 6,000 or so stocks to add to my list!) Some of these names have seen their market values plummet substantially. Losing stocks, no matter how oversold they look, are always ripe candidates for tax-loss selling.

If you’re working with any clients that own a large position in Bank of America (BAC), but they’re reluctant to sell the stock at a loss, try to reason with them. You can begin by simply asking them, “Why do you own Bank of America?” Listen closely to how they respond. And you’ll be surprised by what their answers reveal.

Yielding to Yield The client may tell you they own BAC because of its attractive yield income. In that case, you’d want to emphasize replacement ETFs consistent with an investment style that emphasizes dividend income. In this instance, anyone of the value oriented funds like the iShares Morningstar Large Value ETF (JKF), SPDR DJ Wilshire Large Cap Value (ELV) or the Vanguard Value ETF (VTV) would be good funds to replace BAC. Explain to your clients it’s a large gamble relying on the dividend income of one stock. Help them to grasp that their income strategy will blow up if BAC suddenly halts or reduces its payout. What then? Disaster can be averted by owning a diversified income-oriented ETF.

You might even point out to clients that BAC may be one of the holdings within the very ETF you’re recommending. In other words, they still get to own BAC, plus all of the other great companies that comprise the fund. They get greater diversification, which reduces their risk and furthermore, they still maintain the same investment style or strategy they’ve been attempting to accomplish.

As Figure 1 illustrates, individual stocks can also be matched up according to their market size or industry sector. Following the same example, Bank of America can also be viewed as a play on large company stocks or a play on the financial sector. Again, ask your clients why they own the stock. They may own Bank of America because it’s a huge bank with a national presence and they’re frightened to death of owning small, potentially weaker financial institutions. If market size is their hot button, direct their attention to large company ETFs like iShares Russell 100 (IWB), the SPDR S&P 500 (SPY) or the Vanguard Large Cap ETF (VV). Each one of these funds holds large company stocks with market sizes $10 billion and above.

If that’s still not big enough for them, show them the Rydex Russell Top 50 ETF (XLG) or the Vanguard MegaCap 300 ETF (MGC).

Sector Strategy Other clients may be trying to emphasize sector exposure but they just don’t know it. They may tell you, “Financials have gotten whacked this year, but their going to make a big comeback in 2009.” Maybe they will, maybe they won’t. But don’t make the mistake of arguing or debating with clients about what they already have fixed in their mind. You don’t have to be a mind reader to understand they want exposure to financial stocks. But show them how owning one financial stock like Bank of America, Goldman Sachs or whomever else isn’t helping them to accomplish their goal. Explain to your clients that it’s impossible for one stock, no matter how big or well-respected, to represent the performance of an entire industry sector.

If they want sector exposure to financials they shouldn’t be using just one stock. They should do what professional investors do. Point their attention to financial ETFs that can help them to achieve their goals. If financials rebound, and we’d all be fools to think they won’t, the clients will love you and you’ll become their first source of trusted advice.

The same concept of replacing individual stocks with ETFs can also be applied to actively managed mutual funds. There’s no sense in keeping dead money inside an underperforming fund indefinitely. If your clients are happy with their asset allocation and their overall investment strategy, the solution to their problem may simply be a matter of replacing a rotten performer. Large-cap mutual funds can be replaced using large-cap ETFs. Likewise, the same applies to active funds in other categories.

Perhaps a value manager has gotten creamed because of horrible stock picks. Realizing a loss and replacing that manager with a value-oriented index ETF can make a lot of sense. Because ETFs cover a broad swath of major asset classes, identifying corresponding funds to replace the deadbeat performers is easily done.

Tax Savvy Needed Coordinating gains and losses makes financial sense. Realized losses not only offer the chance to reduce taxable income but the opportunity to sell gainers without incurring tax liabilities. Therefore, matching capital gains with capital losses is the smart thing to do. This is sometimes referred to as “tax-loss harvesting.” For portfolios with either large capital gains or losses, making sure both are realized in the same year can help reduce the stress of taxes.

An impediment to selling an investment is sometimes onerous tax rules. By using ETFs as portfolio substitutes you can help your clients to work around rules like the IRS wash-sale rule. This rule disallows investors to claim losses on the sale of substantially identical securities if those securities are bought within the 30 days before or after the sale. Here’s an example: If your client decides to sell GE at a loss, replacing it with XLI, which contains some exposure to GE along with other industrial stocks, can help them. Since XLI is not GE they can realize a loss and continue to maintain market exposure without having to wait 30 days to reinvest the sale proceeds.

“Tax laws currently favor long-term gains over dividend and interest income in two ways: Capital gains face lower tax rates and incur tax only when realized,” states David Swensen, author of Unconventional Success: A Fundamental Approach to Personal Investment (Free Press 2005).

Furthering Swensen’s point, the cost differences between short-term and long-term capital gains are significant. For example, holding an investment for one year or longer can translate into a maximum tax liability of just 5 percent or 15 percent of the gain, depending on the investor’s tax bracket. On the other hand short-term gains on investments held for one year or less are taxed at ordinary income tax rates. This can result in higher tax liabilities, especially for high income earners.

Here’s one other tip: To qualify as a long-term gain, the holding period begins on the day after your client purchases the investment. So while you don’t count the day they buy, you do count the day they sell.

Don’t underestimate the danger of ignoring the high cost of taxes. By taking a few simple steps with portfolio tax planning you can help clients to avoid the financial pitfalls suffered by the investing masses. ETFs aren’t perfect, but they are flexible financial products that have a place in any well managed portfolio. All of this can go a long way toward avoiding a taxing situation.

Ron DeLegge is the San Diego-based editor of


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