Given the increasing importance of tax management, many advisors understand the basics when it comes to tax-loss harvesting. Yes, it’s about enhancing after-tax returns—or “tax alpha” as it’s often called—but there are other, less obvious benefits advisors should communicate to their clients to convey the full value of this approach. This piece provides an easy-to-understand framework for doing that.
Let’s start with the basics. Tax-loss harvesting is the process of selling investments that declined in value to realize tax losses and reduce overall capital gains tax, saving your clients money. After all, it’s not what they earn—but what they keep—that matters.
The key potential benefits of tax-loss harvesting can be boiled down to 5 points:
1. Saving money on this year’s taxes: With a systematic approach, all portfolio positions are monitored year-round for opportunities to capture tax losses. Once a tax loss is captured, the position gets replaced with a similar position, called a proxy, and the tax savings are based on your client’s capital gains tax rate as that loss can be used to offset gains elsewhere on their taxes—saving them from paying that money to Uncle Sam this year.
2. Time value of money: The concept is that money available at the present time is worth more than the identical sum in the future due to its potential earning capacity. So, not needing to pay that money to the government in taxes this year leaves your client with more money to invest and allows them time to earn a return on in the future.
3. The possibility of converting short-term gains into long-term gains: If the proxy that was bought goes on to recover the amount of the loss originally captured, or even grows beyond that amount, then when that gain is eventually realized on the proxy – what you’ve really done is defer that gain your client didn’t have to pay taxes on earlier because of tax-loss harvesting.
Since-short term capital gains are taxed at your client’s ordinary income tax rate and long-term capital gains are taxed at rates ranging from 0% to 15% to 20% depending on their financial situation, if you offset a short-term gain and defer that amount of gain out to the long-term, then when your client does eventually pay taxes on that gain, it will be at a much lower rate.
4. Longer-term deferrals: If your client can defer some of these gains long enough, they may be able to hold on to them until a time when they have lower income, and therefore a lower tax rate.
5. Estate planning benefits: If these gains can be deferred in an account that gets left as part of your client’s estate, then it may be eligible for a “step up” in cost basis, avoiding paying any taxes on those capital gains. A step-up in basis adjusts the value of an asset when it passes from an owner to their heir, potentially lowering the capital gains of the recipient.
Most advisors perform tax-loss harvesting at year-end, but research has shown that innovative advisors, who use a systematic approach to harvesting losses on a year-round basis, can make a real difference for their clients.
With all of these potential benefits of tax-loss harvesting considered, are you motivated to move to a more automated, year-round approach and communicate that value to your clients? Schedule some time with us to learn more, start the new year fresh and see how much value you can retain or grow in 2022.