One of the most significant ways advisors can provide value to their clients’ portfolios is by managing their tax implications through tax-loss harvesting. For clients looking to minimize their tax liabilities on anticipated realized gains in their portfolios, tax-loss harvesting strategies provide opportunities to generate losses that could create tax alpha and reduce their tax bills at the end of the year.
Researchers at MIT and Chapman University calculated that tax-loss harvesting yielded almost an additional 1% annual return each year from 1928 to 2018. Recent research by Columbia Business School professor and chief investment officer Harry Mamaysky, suggests the “alpha” from tax-loss harvesting is between .30% and .65%, depending on the design of the models used in any estimates, with most of the benefits accruing in the first few years of the strategy.
Here are a few ways uncovering tax-loss harvesting opportunities through rebalancing can help deliver more value to your clients.
Market volatility equals opportunity
Tax-loss harvesting typically thrives in volatile market conditions that are challenging to navigate. It’s no wonder that the market volatility of the past few years has made tax-loss harvesting even more appealing. Market conditions in 2023 have been more favorable for investors than in 2022, even with lingering volatility, inflation, and uncertainty about rising interest rates.
While having a positive performance within a portfolio is beneficial, it’s crucial to thoroughly understand its source and characteristics to minimize taxes in the investment management process. This should provide an extra benefit to clients who expect their advisors and managers to assist them in lowering tax obligations while still having the opportunity to take advantage of the market’s upside.
The crucial role of capital gains budgets
Avoiding short-term capital gains is the simplest example of a permanent tax savings strategy. In contrast, location optimization, which places an investment in the most appropriate type of account to minimize taxes, can provide permanent and temporary tax savings. Establishing capital gains limits can help control your clients’ annual tax burdens by automatically setting budgets for short-term, long-term, or combined capital gains based on a dollar value or as a percentage of the overall portfolio.
The potential benefits of tax-loss harvesting can be further prolonged by enabling clients to add cash to their accounts, gift appreciated securities to a donor-advised fund, and regularly rebalance their portfolios to create fresh tax lots.
In addition, advisors can help their clients navigate the tax and estate implications of The SECURE 2.0 Act of 2022. By rebalancing at least quarterly, advisors can harvest their clients’ material losses during the year, avoid material capital gains distributions, and adjust the location of assets in retirement accounts for maximum tax benefit.
Tax-loss harvesting at the household level
Many advisors are moving towards householding structures due to their clients’ increasing demand for location preferences and tax efficiencies. Reviewing risk profiles across accounts within a household is also crucial to assess the proper alignment between risk tolerances, preferences, and capital gains budgets.
Optimizing the location of assets in various types of accounts can significantly reduce the tax impact of the portfolio. Therefore, rebalancing should also enable you to define location preferences across taxable, tax-deferred, and tax-exempt statuses. Rebalancing can help the advisor reduce or eliminate the client’s tax consequences and offer wash sales logic across the household to maximize tax efficiencies and meet compliance requirements.
Direct indexing becomes more accessible
A direct indexing strategy can provide greater customization than can be achieved with ETFs or mutual funds while helping to minimize taxes through tax-loss harvesting. Wealthy investors with substantial assets have employed direct indexing to lower their yearly tax obligations for quite some time. But many more middle-class and mass-affluent investors also use tax-loss harvesting to reduce taxes and enhance their wealth.
Unlike mutual funds or ETFs, direct indexing allows investors to harvest losses for each individual security. Furthermore, because investors have direct ownership of the individual stocks in their direct indexing accounts, they can capture losses even in a year when the overall index shows gains in value.
Technology’s integral role in tax-loss harvesting
Cutting-edge rebalancing technology empowers effective tax-efficient investing and enables tax-loss harvesting to be carried out systematically and continuously. A rebalancing platform should allow you to quickly harvest tax gains or losses and utilize substitute securities to maintain market exposure while avoiding potential wash sales. It should also provide capabilities for:
- Alerting advisors when a trade is at risk of breaching a pre-specified budget
- Realizing gains or losses at the position or classification level and holistically across investment portfolios
- Considering short-term and long-term gains, capital loss carryovers, and gains generated from the orders themselves
- Factoring in restrictions, minimum trade size, and loss or gain thresholds to influence trade recommendations
- Offering different methods of harvesting gains and losses, including closing the position, selling lots based on cost basis method, and selling specific lots
The key is tax-sensitive rebalancing
As the end of the year quickly comes into view, understanding when, why, and how to engage in tax-loss harvesting efforts is crucial. But initiating a tax-aware investment strategy shouldn’t be a once-a-year activity.
Applying tax-sensitive rebalancing techniques throughout the year ensures you consistently meet your clients’ investment policies and tax efficiency goals. Rebalance at least quarterly, harvest material losses during the year, avoid material capital gains distributions and adjust the location of assets in retirement accounts for maximum tax benefit. Some advisors take a continuous rebalancing approach by looking at the portfolio daily for an opportunity to realize losses in the portfolio.
Embracing ongoing, tax-sensitive rebalancing can ensure you’re well-prepared for year-end tax considerations and consistently aligned with your clients’ investment objectives and tax efficiency targets. It’s a proactive strategy that can make a meaningful difference in your clients’ long-term financial success.