Strategies to Reap the Rewards of the Tax Loss Harvest

In the northern hemisphere, farmers typically reap their harvest in the fall, but wealth managers reap theirs in the spring.

Tax loss harvesting involves selling stocks, bonds, mutual funds or other investments that have lost value to trim taxes on realized capital gains from winning investments.

The filing deadline for 2016 income taxes is April 18, a month away. Any buying and selling for 2016 has likely already taken place, but it’s worth highlighting strategies used to the reap the rewards of the tax loss harvest.

At the core, tax loss harvesting is all a matter of controlling taxes owed on investments, said Richard L. Bergen, owner of RLB Wealth Planning in Garden City, N.Y.

“Clients are receptive and appreciate the service because it's not easy to do,” he said.

No, it’s not.

Advisors like Gregory D. Gardner in Dallas spend about 75 percent of the final two months of the prior calendar year talking to clients about projected tax bills and how to reduce overall taxes due to the IRS, Gardner said.

Tax loss harvesting is a “key component” of Gardner Group’s financial planning strategy to reduce the overall tax bill for clients, he said.

Any well-diversified portfolio is bound to contain losses so it’s just a matter of turning those losses to a client’s advantage.

Cue the tax-loss harvesting software tools to help advisors identify which investments belong to their 2016 tax loss harvest.

TRX rebalancing software from Morningstar helps advisor John T. Gugle, principal of Alpha Financial Advisors in Charlotte, N.C., look for harvesting opportunities when a security or a basket of securities drops by 15 percent or $5,000, he said.

Big mutual funds, broker/dealers and insurers offer plenty of help too.

Keys to effective tax-loss harvesting include identifying investments that have lost value, knowing your capital-gains tax rates, avoiding “wash” sales and updating cost-basis account methods, according to a tax loss harvesting primer on Fidelity’s website.

Assess Short, Long-term Capital Gains

Advisors who frequently buy and sell probably will have short-term or long-term gains and losses on the trades so advisors need to be alert to the capital gains tax rate, Fidelity said.

For buy-and-hold mutual fund investors, projected distribution dates for capital gains are paramount and advisors should stay on top of capital gains distributions of the fund, Bergen said.

Estimate Capital-Gains Tax Liability

Short-term capital gains are taxed at the client’s marginal tax rate on ordinary income and the top marginal tax rate on ordinary income is 39.6 percent. This rate applies to couples filing jointly with income above $470,700, and single filers with income over $418,400.

More about tax rates and tax brackets can be found here.

For filers subject to the net investment income tax of 3.8 percent, their effective tax rates can rise as high as 43.4 percent, not counting state and local income taxes, Fidelity said.

Long-term capital gains are not taxed if taxable income comes to $75,900 or less and you are married filing jointly, or $37,950 or less for single filers. For most taxpayers, the long-term capital gains rate is 15 percent.

Harvest Losses, Prioritize Tax Savings

Once advisors figure out how much a client owes in capital-gains tax, the time is right for advisors to hunt down the tax-loss selling candidates.

As much of a capital loss as possible should apply to short-term gains since short-term gains are taxed at a higher marginal rate, particularly for high-income investors, Fidelity said.

Short-term losses must be used to offset short-term gains and long-term losses must be used first to offset long-term gains, Fidelity also said.

Even if investors don’t realize capital gains this year, advisors can apply up to $4,300 in capital losses to reduce ordinary income, which is taxed at the same rate as short-term capital gains and nonqualified dividends, Fidelity said.

Beware of Wash Sales

A tax write-off is disallowed, however, if advisors buy the same security, contract or option to buy the security, or a “substantially identical” one, within 30 days of the date the advisor sold his or her losing investment, Fidelity said.

Advisors can avoid a wash sale by buying exchange traded funds targeting the same industry sector, but beware. Some substitutions are allowable, but not in the case of what the IRS considers “a substantially identical security,” Fidelity said.

That’s where the rebalancing software comes in handy.

“We use our rebalancing software to ensure we do not run afoul of the wash sale rule, so we make sure we do not go back into a particular security for 31 days after we harvested a loss,” Gugle said.

Harvesting, a Year-Round Strategy

Tax loss harvesting is the flip side to portfolio rebalancing, so there’s no hard and fast rule about how often to harvest.

Some advisors harvest once or twice a year, others more frequently as advisors absorb winners and ditch laggards.

Capturing temporary losses to offset other realized gains “allows us to keep investment-related taxation at a lower current level,” said Kevin M. Gahagan, a financial planner with Mosaic Financial Planning in San Francisco.

“It needs to be acknowledged that this isn't a free lunch and it doesn't eliminate the eventual taxes that will come due,” he said. “This is a tax deferral strategy. It does defer the timing of when taxes may need to be paid.”

As farmers know all too well, no fall or spring harvest was ever a free lunch.

InsuranceNewsNet Senior Writer Cyril Tuohy has covered the financial services industry for more than 15 years. Cyril may be reached at [email protected].

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