Harvest season comes more than once a year: Why the right plan is essential to tax-loss harvesting success

Tax-loss harvesting has quickly come back to the table in conversations with clients, and likely will become part of the tax planning discussion as we turn the corner towards the end of the year. The volatility we saw in 2020 during the pandemic sell off may very well be overshadowed by the market volatility we’ve seen this year, due in part to the pressing topics in the headlines during the first half of 2022.

Recently, Ben Henry-Moreland authored a research article titled “Why Tax-Loss Harvesting During Down Markets Isn’t Always A Good Idea” on Kitces.com. In this piece, he questions the potential impact of tax-loss harvesting for the sake of tax-loss harvesting and that it may be counterproductive or harmful.

While we agree with the overall sentiment, as a firm our goal is to perform tax-loss harvesting with a purpose. This includes executing harvesting with strategic intent and as efficiently as possible, seeking better outcomes for advisors and clients.

Money in Motion – Shifting legacy assets to a target model

Taxes, in the asset transition process, play an increasingly important factor for advisors and clients as markets continue to rise regardless of the ongoing volatility. Advisors unfortunately have difficulty building plans to shift concentrated or legacy assets towards a structured model that aligns with their client’s stated financial goals, without creating a burden from the resulting tax bill.

For advisors looking to transition concentrated holdings or make risk-adjusted investment decisions, 55ip’s technology evaluates hundreds of lots within a portfolio to determine which positions can be opted for a loss and match those losses up with positions at a gain. The ability to free up a sleeve of the client’s overall allocation towards a model portfolio then allows 55ip to continuously tax-loss harvest a comingled portfolio of legacy and model assets.

The legacy assets in the basket lock in their gains, but with an offset of new tax lots from the model portfolio capturing losses. Over time this is done without burdening the advisor with the technical calculations of reducing a concentrated portfolio and without burdening the client with an excessive tax bill associated with diminishing the portfolio. The fundamental of this transition has been a byproduct of tax-loss harvesting and, according to our most recent advisor survey, tax transition was ranked highest by advisors when considering the value we provide to their clients.¹

Assets within legacy investments, such as mutual funds, have also repeatedly been taxing for clients’ portfolios. After nearly a decade the assets have risen in value making it increasingly more difficult to shift a client from mutual funds to ETF to reduce cost, but more importantly the factor of capital gains distributions annually may have been a silent factor contributing to a client’s tax bill. As advisors utilizing 55ip would point out, over time the use of the 55ip tax transition technology has leveraged tax-loss harvesting as a strategy to execute further conversion of legacy mutual fund assets to ETFs while generating little to no additional realized tax bills.

The “secret-sauce” of 55ip’s approach to Tax-Loss Harvesting and avoiding the wash sale rule

In order to implement effective tax-loss harvesting, 55ip utilizes a set of proxy securities to avoid wash sale rules set by the IRS, while taking advantage of volatile markets. In situations like we’ve seen this year, 55ip evaluates each position and each tax lot to determine if and when to harvest losses through our Optimal Loss Threshold (OLT) process. OLT sets unique loss thresholds to each position within the portfolio to gauge if harvesting losses now would be more optimal than waiting to harvest the loss later. If the TLH trade is completed, then 55ip will introduce the proxy security into the portfolio, without having the client or the advisor need to wait 31 days to reinvest, leaving valuable cash in the model, rather than on the sidelines until wash sale rules have passed.

Planning: 55ip’s intelligent automation provides an “always on” view into your client accounts

As we think of tax planning, the traditional approach of setting up tax-loss harvesting trading in November for the sake of doing tax-loss harvesting is counterproductive to the word planning. Planning is about the ability to develop a joint goal that the advisor wants to achieve for their client and the goals of that client. In order to plan, processes must be put in place.

Processes such as monthly checks and balances to ensure each individual security, and its individual tax lots, are reviewed to ensure the movements in the market haven’t created opportunities to harvest multiple times throughout year rather than just in November. Vanguard conducted a study² in which monthly TLH added nearly 50 bps in additional tax-loss harvesting for clients when compared to TLH done simply on an annual basis.

55ip then captures those monthly benefits for transitioned clients into a consolidated quarterly tax savings report for advisors to engage in a proactive discussion with their client four times a year, rather than November or April when taxes are typical top of mind. The Tax Savings Report allows the advisors then to have these critical conversations with every relationship each quarter to demonstrate their value in great markets when an advisor may be able to produce alpha, as well as in bad markets when 55ip is able to generate alpha in the form of Tax Savings.

Time: The power of converting short-term gains into long term

Lastly, the factor of time plays a critical part in whether tax-loss harvesting is a valuable strategy for clients. When creating tax-loss harvesting opportunities the tax bill isn’t diminished in some scenarios, it’s simply deferred. However, the deferral of taxes is still an effective strategy when considering taxation rates fall when moving from Short-Term to Long-Term taxes. In fact, 55ip processes trades to recognize short-term gains against short-term losses, long-term gains against long-term losses, and remaining short-term losses will be matched up with long-term gains systematically endorsing a higher applicable tax rate position to be used against a long-term gain, diminishing the impact of that loss by reducing taxes. 

The same is said when 55ip completes a tax-smart withdrawal from the client’s account, reviewing each lot in an investor’s portfolio. By doing so, the withdrawal needed by a client is done in a tax efficient manner determined by selling selected lots.

As a leading tax management technology provider to Financial Advisors, 55ip believes in the power of tax-loss harvesting with a purpose and with efficiency. This approach empowers advisors to have these critical discussions with clients to understand how planning in general as well as tax planning is a fruitful way to support clients to pursue financial success.

Footnotes

¹ 2021 55ip Advisor-client survey

² November 23, 2021 | Vanguard Perspective: Tax-loss harvesting: More than a year-end tax strategy

Past performance does not guarantee or indicate future results and there can be no assurance that any investor will achieve comparable results or that any return objectives will be met. No representation is made that any investor will, or is likely to, achieve results comparable to those shown. All investments involve risk, including loss of principal. 

The impact of a tax-loss harvesting strategy depends upon a variety of conditions, including the actual gains and losses incurred on holdings and future tax rates. The results shown in these materials are hypothetical and do not represent actual investment decisions.

The tax-loss harvesting service is available for an additional advisory fee and the results shown represent the net effect of the advisory fees but may not consider the impact of fees charged by others, including transaction costs or other brokerage fees. The information contained herein is subject to change without notice, is not complete and does not contain certain material information about the investment strategy, including additional important disclosures and risk factors associated with such investment and information about fees, trading costs and taxes. Neither the U.S. Securities and Exchange Commission nor any state securities administrator has approved or disapproved, passed on, or endorsed, the merits of this document. More information at www.55-ip.com.