Playing the Long Game With Your Clients’ Tax Strategy

Leveraging the Power of Volatility

A tax-smart investment management strategy affords advisors a bit more control over normal portfolio volatility. Brief periods of decline — whether in March or October — can provide opportunities to reduce the current year’s tax burden and potentially increase the client’s long-term wealth. Even a half-percentage-point increase compounded year over year can add up to a significant amount of money that would have otherwise been left on the table. 

Long-Term Opportunities

Tax loss harvesting effectively delays the realization of capital gains taxes, and when those taxes are eventually paid, it will hopefully be at a reduced rate.

As an example, consider the graphic below.

Compared with a traditional buy-and-hold approach that directs a client to ride out market declines, if a client instead harvests a short-term capital loss, the client can then use that loss to offset a short-term capital gain from elsewhere on their tax return, creating more value by the amount of the applicable short-term capital gains rate on the harvested loss (a tax deferral here of $816 on a $2,000 loss). 

• The harvested security (Security A) will be replaced by a proxy that has a similar exposure (Security A Proxy) to maintain the desired investment allocations in the portfolio.
• Due to the decline in value that led to the loss, Security A Proxy costs less than the original purchase price of Security A — meaning that Investment B has a lower cost basis.  
• If the proxy is sold much later for a significant capital gain, that gain will be bigger by the amount of the harvested loss, which has allowed the investor to defer the capital gains tax for that amount of time.   

This mechanism has the potential to allow investors to leverage the deferral of taxes in a long-term strategy that could include the following benefits for the investor:

• Amplifying the time value of money — instead of being used to pay taxes, the amount of money saved as deferred taxes may be invested by the client, allowing that amount to earn compounded returns over time.  

• Converting short-term into long-term capital gains — in the deferral mechanism described above, if a short-term gain gets deferred into a long-term gain, the tax eventually paid could be significantly less. 

• Deferring taxes until client is in lower tax bracket — or sometimes avoiding them altogether, if passing wealth as part of an estate plan, due to the step-up of cost basis upon death.

The Basis of a Dynamic Long-Term Strategy 

Not all clients can afford to pass on their portfolio to their heirs; they may need to draw on it to support their retirement. Therefore, many portfolios will need to be liquidated eventually, and these deferred gains will be realized. 

Over time, gains will also need to be realized for periodic portfolio rebalancing to maintain the desired investment allocations. But even in those cases, the client may still have been able to defer the realization of these gains for years, holding on to their money and being able to make use of it for longer.

Technology empowers advisors to scale sophisticated tax management capabilities, differentiating their practice and adding value for their clients. Benefits of ongoing loss harvesting can provide immediate tax relief in the current year — but the value is most notably seen in the long run, when savings compound over time. 

Dennis Follmer is head of client portfolio management at 55ip. Over the last 25 years, he has garnered extensive portfolio management and leadership experience at several firms and launched multiple investment businesses, including as a founding partner of Oceanwood Capital Management, a $2 billion hedge fund spinoff from Tudor Investment Corp. Dennis holds an MBA from the Sloan School of Management at MIT, and graduated summa cum laude with a bachelor’s degree in finance from Miami University.