Tax-Loss Harvesting: 5 Keys to Doing It Right for Each Client

As 2021 starts winding down, many advisors will likely start ramping up their work related to clients’ tax-loss harvesting, according to Joel Dickson, principal and head of enterprise advice methodology at Vanguard.

For advisors, tax-loss harvesting should not be a one-size-fits-all proposition and, depending on investor characteristics and market conditions, a wide range of outcomes can be realized, he told ThinkAdvisor on Tuesday in a phone interview.

Much of that variation is driven by the specific characteristics of each investor, he said. Based on the findings of recent Vanguard research, he said, “over long periods of time, [through] different market environments and so forth, about 60% of the differences in tax-loss harvesting result from the investor profiles.”

The remaining 40% come from factors that are “outside of the investor and the advisor’s control” — mainly, the “market environment you’re in,” he said.

Advisors should take all of these factors into account when tax-loss harvesting, he added.

Here are five key issues advisors should consider when tax-loss harvesting:

1. What is the tax rate that the specific client faces when harvesting losses?

This is the most obvious issue and can perhaps be figured out easiest.

2. What is the tax rate going to be when the client will potentially realize any gains from the harvesting?

In other words, when liquidating or withdrawing the investment, what is the projected tax rate for the client going to be?

For one thing, there could be a change in tax rates due to pending or proposed tax changes, especially if your client has a high net worth.

Important to factor in, Dickson said: How does the future expected tax rate for a specific client compare to the current tax rate? And “how many taxable gains do you expect this client to have from kind of all sources” without factoring in any tax-loss harvesting?

3. What is the amount of gains that the client has to offset the losses?

“This is one of the big things that, I think, has been glossed over in the discussion” of TLH most of the time, Dickson said.

“Most of the TLH benefit when people come up with estimates assumes that every dollar of loss can offset some gains and, therefore, you generate immediate tax savings all the time,” he said.

“And we just don’t see that in … investor profiles,” he said, adding that “typically, even high-net-worth investors don’t have really, really large capital gains realizations each year that would benefit from more and more losses.”

That is why, instead of focusing on the losses you may generate through TLH, it’s “the amount of gains that are available to offset with losses that is the key driver,” he explained. If you don’t factor all this in, you may be taking on some unwanted risk, he said.

So it would be a good idea to ask your client if they plan to sell a business or real estate holdings and, if so, when.

“It’s really critical to think about what are those aspects of the investor profile that can best be leveraged to deliver the best tax alpha to a particular client rather than an average client,” Dickson added.

4. What is the market environment?

“If you have a market environment like … 2000 to 2010 or 2015, you’ve got some big, big drops in the market and then some recoveries, you actually have a lot of loss opportunities that can offset gains that can lead to a lot of tax alpha,” he explained.

However, “if you’re going through, like, the 1990s, where it’s just a slow, steady climb generally in the market overall, there were a lot fewer relative opportunities for tax-loss harvesting and you have very different expected returns in those environments,” he said.

5. Focus on the ‘knowns.’

An advisor is free to predict the future performance of the stock market based on their projections for the economy and other factors. But it’s best for the advisor to remain focused on the things they and the client have control of and that are actually known, according to Dickson.

(Pictured: Joel Dickson, principal and head of enterprise advice methodology at Vanguard)