When life gives you lemons, you make lemonade. My grandmother repeated that to me innumerable times, and I think it might be a very relevant thought as unsettled financial markets and the year-end seem set to collide. Many financial advisors review their clients’ portfolios at year-end with an eye on reducing clients’ tax bills through loss harvesting. The fact that there are losses is typically a somewhat bitter realization, but this situation may have a sweet side too. Let me explain.
Commonly, the reason for looking at tax-loss harvesting opportunities is that a client has realized capital gains, which can be the result of using actively managed funds in taxable registrations. Given the historical tax inefficiency of most of the strategies used in managing these funds, they should ideally be held in tax-advantaged registrations, in line with sound asset location practices. But sometimes that’s not immediately possible.
In my previous life as an advisor, I typically saw this situation with the portfolios of newer clients, where the potential future tax inefficiency of their actively managed funds was trumped by the actual taxes that they would owe on the embedded gains if we sold at the time. For advisors with client portfolios in this predicament, the recent market sell-off may provide several benefits.
First, the embedded gains in the funds held in taxable registrations may be eroded with the market retreat, lessening the embedded tax liability. Second, any losses that may exist—either for entire positions or at the tax-lot level—can be used to offset realized gains. Third, to the degree that excess losses remain, they may be used to reduce or eliminate the tax-inefficient funds held in taxable registrations. To maintain the portfolio’s asset allocation, a potentially more tax-efficient fund—such as a broad-market index fund or ETF—might be used as a replacement for the positions sold.
Investing requires bearing risk in pursuit of reward, and much as we all love to see gains in our portfolios, losses, too, are a fact of life. However, losses need not always be bitter and sometimes may help us not only make a client’s current tax bill less onerous but also improve the portfolio’s expected tax efficiency every year thereafter. Combining year-end tax-loss harvesting with an effort to improve a portfolio’s asset location is one way we believe advisors can add value to their client relationships, and it is a great way to turn a potentially unpleasant conversation about losses in the portfolio into a sweet approach to improving the client’s expected after-tax returns in the future.
All investing is subject to risk, including the possible loss of the money you invest
This information does not constitute legal or tax advice. We recommend that you consult a tax or financial advisor about your individual situation.
Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could perform worse than the original investment, and that transaction costs could offset the tax benefit. We recommend that you consult a tax advisor before taking action.