Longfellow famously said, “Into each life some rain must fall.” In the world of investing, we modify that to, “Into each portfolio some loss must occur.” On the bright side, there is sometimes a way to create a ray of sunshine from the downside of a loss.
Clients of Smith and Howard Wealth Management (S+HWM) benefit from our association with Smith and Howard, a nationally recognized accounting firm. This association, with its access to the entire tax group of Smith and Howard, coupled with my 25-plus years of tax experience, mean that we maintain an expert, tax-aware approach to our clients’ investments. Among the strategies resulting from this expertise is the very specialized and disciplined approach to tax-loss harvesting.
How Selling a Losing Stock Can Reduce Your Taxes
Tax-loss harvesting, if done properly, is a method of reducing an investor’s tax liability on securities that have experienced a loss. This is achieved by selling the security that has experienced a loss and buying a security in a similar asset class. While using the loss to offset a capital gain in another security, the purchase of a security in a similar asset to replace the losing one also preserves the optimal balance among diversified assets.
For example, a hypothetical client named Stewart brings cash he wants SHWM to help him invest. Taking into consideration his financial goals and investment risk-tolerance level, we may advise and recommend 10 different investments. Several months in, it becomes clear that two have underperformed. This is not entirely unexpected, since in any well-diversified portfolio, there will be some losers (that in different market conditions will be winners).
Meanwhile, the winners in Stewart’s portfolio have created gains that the government is going to tax. By selling the losing stocks, we trigger a reduction in his tax liability that offsets the capital gains tax on the winning investments’.
Strategies for Maximizing Gains
Our purpose, however, is not just to target a loss. It’s crucial that the proceeds from the sale of the losing issue are reinvested immediately in order to maintain the optimal exposure to the market. We maintain a list of comparable investments to make happen – and happen quickly.
For example, by liquidating your U.S. small-cap holding, we can buy another similar U.S. small-cap holding so you’re still invested in that sector of the market.
Another benefit of this strategy: since you’re likely switching from the old stock to the new one at a time when the market is down, you’re buying at a relatively low price when there’s better potential for growth.
At S+HWM, we proactively monitor client portfolios for tax-loss harvesting opportunities all year, not just at year-end when taxes are on everyone else’s minds. The commitment and expertise in doing this throughout the year can potentially make a tremendous difference in portfolios and in tax liability. It is especially important when markets are volatile. Roller coaster conditions can rock an investor’s asset allocation balance, creating overexposure in securities that may be heading for a loss and underexposure in those that have opportunity for gains.
For example, consider the example of tax-loss harvesting we did during February 2018 and March 2020 during the during periods of market weakness. Various equity positions were all down during those months. By selling positions that were at a loss and replacing those positions with substitute funds with the same objective that we had already vetted, we were able to lock in tax losses. Buying the substitute funds at the same loss, clients ended up being very well-positioned when those stocks came back up by the end of the year. They enjoyed a gain, which was unrealized at year’s end and therefore not yet taxed. With markets rebounding quickly and meaningfully anyone waiting until November or December to tax-loss harvest completely missed their opportunity. Looking at a trust account that started with a value of $1,000,000 and had gained closed to $340,000 in value over five year, we have been able to maintain tax loss carry forward for future years.
The tax savings and the earnings on those savings we estimate totaled $14,000 or about 1.4% of the beginning $1,000,000 balance. That amounts to an annual increase in returns of roughly 0.25% to 0.30%. The account also has unused tax loss carry forwards that have future value. If we translate that $63,000 into tax savings at the long-term capital gains rate of 23.8% that is roughly another $15,000 of benefit to the client, or an added 0.25% to 0.30%. The estimated annual percentage benefit to client equals +0.50% to +0.60%
Why Smith + Howard Wealth Management Differs from Other Firms
Unlike S+HWM, most advisors miss the opportunity to capture one of the biggest (and easiest) value adds available to investors – tax loss harvesting. The reasons vary, but include:
- Firms are too busy trying to generate new business
- Firms only look for tax-loss harvesting opportunities at the end of the year
- Firms are using managed portfolio programs that don’t allow for tax-loss harvesting
- Tax-loss harvesting would negatively impact the portfolio composite return data they report
- Advisors are managing too many relationships and unique holdings act quickly and monitor opportunities
Beware the Wash Sale Rule
The IRS’s wash sale rule says that if you sell something at a loss, you can’t re-purchase it for 30 days. Some people make the costly mistake of using the proceeds to buy a different stock that they hold for 30 days before selling it – at a gain or a loss – and getting back into their original investment. The problem with this approach is if you’ve had a gain on your temporary investment, you’ve just triggered a short-term gain, which is more expensive from a tax perspective than a long-term gain. For our typical affluent client, it’s twice as expensive.
What’s more, when you go back to your original investment, if its value has increased, you’re buying back in at a higher price. When we reinvest our clients’ proceeds from the sale of a losing issue, we put them into a quality investment that’s worth holding beyond the short-term gain threshold. They don’t go back to the old stock.
Following a Plan, Not Instinct
While it sometimes makes sense to hold a losing security until it bounces back, there are times when opportunity for tax savings and reinvesting at a lower price is the most prudent plan. In addition, tax loss harvesting lowers your basis. If you don’t plan to liquidate your investments in the future, this can mean higher taxes. It is often a prudent approach for those who plan to pass their investments to heirs (who will get a stepped-up basis) or who plan to donate all or some of their assets to charitable organizations.
Tax loss harvesting is a complex process that requires a high level of combined expertise in taxes and investments and is a key component of the services we provide SHWM clients. We approach it methodically and consistently with each client’s financial situation and goals in mind.
Your Family’s CFO
Whether it’s advice on the best way to optimize the performance of your investment portfolio or how to trim your tax bill, Smith and Howard Wealth Management serves as your family’s CFO. We strive to support you in making the best possible financial decisions to serve your family’s particular situation and goals and bring you financial peace of mind.
Unless stated otherwise, any estimates or projections (including performance and risk) given in this presentation are intended to be forward-looking statements. Such estimates are subject to actual known and unknown risks, uncertainties, and other factors that could cause actual results to differ materially from those projected. The securities described within this presentation do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in such securities was or will be profitable. Past performance does not indicate future results.