Close Close
Popular Financial Topics Discover relevant content from across the suite of ALM legal publications From the Industry More content from ThinkAdvisor and select sponsors Investment Advisor Issue Gallery Read digital editions of Investment Advisor Magazine Tax Facts Get clear, current, and reliable answers to pressing tax questions
Luminaries Awards
Money on a clothesline

Financial Planning > Tax Planning > Tax Loss Harvesting

Tax Loss Harvesting Is Easier With ETFs, but Beware the Wash Sale Rule

Your article was successfully shared with the contacts you provided.

What You Need to Know

  • A brutal year for investors has brought the topic of tax loss harvesting to the fore for many financial planners.
  • While a potentially powerful technique, loss harvesting must be carefully executed to avoid triggering wash sale issues.
  • Clear client communications are of paramount importance in the loss harvesting process.

Speaking recently with ThinkAdvisor, Ryan Losi, an executive vice president of the boutique certified public accounting firm PIASCIK, pointed out an important but often overlooked fact about the exchange-traded fund marketplace.

With the huge proliferation of ETFs in recent years, Losi explained, tax loss harvesting has gotten a lot easier, because advisors can more effectively sell their clients’ holdings as needed and then pick up a similar-yet-distinct ETF that will deliver a similar exposure to what was sold.

According to Losi, wealth advisors should study this dynamic and consider new and emerging ways to efficiently enact tax loss harvesting. This is an especially important moment to do such work, Losi explains, as 2022 has been nothing short of a brutal year for the typical investor, with significant losses being posted on both sides of the typical 60/40 portfolio of stocks and bonds.

Losi noted that, with a substantial degree of tax loss harvesting on the table for Q4 2022, it will be important for advisors and their clients to avoid triggering the wash sale rule. Successfully doing so requires advisors to keep a few fundamental rules in mind, experts agree, beginning with the fact that the Internal Revenue Service doesn’t deem a security sale that generates a loss as being a true sale if the investor turns around and buys it back within 30 days.

Wash Sale Basics for Financial Advisors

As defined on the Securities and Exchange Commission’s website, a wash sale occurs when an individual or entity sells or trades securities at a loss and within 30 days before or after the sale they buy “substantially identical” securities.

Wash sale issues, as the SEC explains, can also be triggered if an investor acquires substantially identical securities in a fully taxable trade, or if they acquire a contract or option to buy substantially identical securities. If an individual sells stock and their spouse or a corporation they control buys substantially identical stock, this would also be deemed a wash sale.

The full wash sale framework is outlined in the annually updated IRS Publication 550, which includes a few helpful examples of how an advisor or client could unwittingly trigger a wash sale issue. In one straightforward example, a theoretical individual buys 100 shares of X stock for $1,000. Later, the person sells these shares for $750 and within 30 days from the sale they buy another 100 shares of the same stock for $800.

“Because you bought substantially identical stock, you cannot deduct your loss of $250 on the sale,” the IRS warns. “However, you add the disallowed loss of $250 to the cost of the new stock, $800, to obtain your basis in the new stock, which is $1,050.”

The IRS’ second example is more nuanced and considers an individual who is an employee of a corporation with an incentive pay plan. Under this plan, the individual is given 10 shares of the corporation’s stock as a bonus award, and they include the fair market value of the stock in their gross income as additional pay. Later, the person sells these shares at a loss.

“If you receive another bonus award of substantially identical stock within 30 days of the sale, you cannot deduct your loss on the sale,” the IRS warns.

This example shows that wash sale issues are not always triggered only by the actions of the advisor or the client, and so it is important to be mindful of things like anticipated equity grants or bonuses when considering tax loss harvesting.

How to Get Loss Harvesting Right

In a new blog post published this week to her firm’s website, Natalie Miller, director of investment strategy at Parametric Portfolio Associates, offers some timely insights for advisors looking to learn more about this important technique.

As Miller points out, bear markets are stressful for investors, but tax loss harvesting is something positive advisors can do in this moment for the long-term financial health of their clients. She says tax loss harvesting is particularly useful, but also potentially more complex from a wash sale avoidance perspective, when clients are being served via separately managed accounts.

According to Miller, it is a sad but sure fact that losses are plentiful in many investors’ portfolios at this moment, but that doesn’t mean the long-term portfolio strategy should change. Rather than abandoning well-crafted, long-term investment plans, Miller says, advisors are probably better off viewing market downturns as an opportunity to collect additional tax losses and reinvest the proceeds to maintain market exposure.

Miller says advisors should not wait to conduct loss harvesting actions merely because they suspect the markets could drop further. However, short of engaging in market timing, it could be beneficial to take a step back and consider the broad direction the markets are heading.

“After an initial loss-harvesting trade, the market may fall further, and investors may notice additional losses in their portfolio, or they may believe that if a loss isn’t harvested immediately, they’ll miss the opportunity,” Miller writes. “Portfolio losses could reduce or continue to deepen on any given day. A method to avoid trading too soon is using a trigger-based approach to harvest losses when they become meaningful.”

Miller says the reinvestment part of the tax loss harvesting equation must be tackled carefully.

“Under its wash-sale rules, the IRS disallows a tax loss if the investor purchases the same or equivalent security within 30 days before or after the sale date,” Miller reiterates. “As a result, it is typically most efficient to trade accounts when there are no outstanding wash-sale restrictions. This is one reason SMA investors may see unharvested losses in their portfolios. It usually means the SMA manager is trying to navigate the wash sale trade restrictions and avoid the risk of nullifying the loss-harvesting benefit.”

In the end, Miller says, success comes from a careful balancing act between risk, taxes and costs, and in the end, limited trading within a wash sale period may in fact be necessary during periods of heightened volatility, to bring the portfolio closer to risk targets and realize deep losses.

The Communication Factor

In a recent column for ThinkAdvisor, Noah Rubin, managing director and financial advisor at the Rubin Wealth Management Group of Wells Fargo Advisors, warns that client communication around tax loss harvesting is not a simple matter.

“As a formerly practicing certified public account, I confidently harvested losses on behalf of clients this year,” Rubin writes. “I then called clients to update them, excited to inform them of this positive proactive move. The reaction from the client was rarely what I expected. It was often confusing, with the most common question being: Why are we selling when you always tell me to hold for the long term?”

To answer this question, Rubin tries to explain in simple and logical scenario A or scenario B choices. Choice A is to have negative performance in line with the negative performance of the markets, while choice B is to have negative performance in line with the negative performance of the markets complemented by a “tax asset” that will save money on taxes in the future.

As Rubin writes, this logic may be clear to an experienced financial advisor, but it is not guaranteed to resonate with clients. In fact, in Rubin’s experience, advisors have often so successfully trained their clients to not sell in down markets that the topic of tax loss harvesting causes substantial confusion and concern.

In such situations, Rubin recommends more technical language that explains how a portfolio can be sold to take losses and still stay invested in a consistent long-term strategic allocation.

“You can teach that while no two funds are exactly alike, mutual funds and ETFs invested in a specific sector or industry can be very similar,” Rubin writes. “Often, we can identify two funds with marginal differences in the underlying holdings. … While they are not the exact same investment, you can comfortably educate your client that their overall allocation and strategy has effectively remained intact.”

The result, Rubin says, is harvested losses that can offset future taxes while keeping the client invested in the long-term strategic plan.


© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.