How to Help Clients Harvest Tax Losses by Year End

As the end of the year approaches, it is a good idea to review your client’s taxable accounts for any capital losses. This isn’t automatically to say that all losses should be blindly taken, but rather these losses can be a planning tool in managing your client’s portfolio and their overall tax and financial situation.

It’s always a good idea to track a client’s taxable gains and losses on holdings such as individual stocks, exchange-traded funds (ETFs) and mutual funds. Next determine which gains and losses are long term and short term as there are rules about matching them and carrying unused losses forward to subsequent years. In the process, don’t forget about any capital gains distributions from mutual funds or ETFs. Often, you can go to the firm’s website to get an estimate of the year-end capital gains distributions. (For more, see: 5 Top Tax Concerns Clients Face.)

Add up the client’s long-term capital gains and match them against any long-term capital losses. Likewise with short-term capital gains and losses. If the net result is positive for long-term gains and short-term gains the client will pay taxes on each at the appropriate long-term gains rate and their ordinary income tax rate for the short-term gains. Other permutations of this matching process allow losses of one type or the other to be used to offset gains of either type.

To the extent that capital losses exceed capital gains in any given year, up to $3,000 of those excess losses can be used to offset other income. Any excess gains over and above that level can be carried forward and used in subsequent years.

Investments held for at least a year and day are taxed at preferential long-term capital gains rates when sold. These rates can be as low as 15% and range up to 20% based in your client’s tax bracket. Additionally, higher income clients will be subject to the 3.8% Medicare tax surcharge on capital gains as well. For 2016 this kicks in for single filers with modified adjusted gross income (MAGI) of $200,000 or higher and for couples filing jointly with MAGI of $250,000 or more. For those who are in the 10%-15% marginal income tax bracket there are no capital gains taxes. (For more, see: Tax Tips for Financial Advisors.)

Short-term capital gains are taxed as ordinary income and for many clients this rate will be considerably higher than the preferential long-term capital gains rates.

Tax-loss harvesting is an investment strategy, realizing losses to save a bit on taxes should not be an end unto itself. That said, using tax losses during normal portfolio maintenance and tracking activities such as rebalancing makes good sense. For example, if you your client has a loss on an investment that is in an asset class where they need to sell some assets anyhow, this is the ideal situation. Simply sell the holding and use the proceeds to purchase other investments in areas that need to be increased to bring their overall portfolio back into balance.

Unfortunately, things are not always this simple. While looking at your client’s portfolio there might be unrealized investment losses that don’t necessarily lend themselves to rebalancing. There are a few options here. One is to sell the asset to realize the loss and buy something else in that same asset class to keep the client’s asset allocation in tact. For example, if the client realizes their loss in a large cap actively-managed mutual fund, they might buy shares of an S&P 500 index fund to keep the money allocated to this asset class.

When harvesting tax losses for a client, beware of the wash sale rules. These rules indicate that the investor must not buy shares of the same holding or a substantially identical holding for 30 days prior to and after the sale. Violating these rules will invalidate the ability to deduct the loss. The substantially identical holding part of this can be open to interpretation. A clear example would be selling an S&P 500 fund from Vanguard at a loss, only to buy one from Fidelity Investments within this period. (For more, see: How Advisors Can Get Good PR During Tax Season.)

This extends to other accounts. If would be a violation to sell the S&P 500 fund in the client’s taxable account and then purchase it in their IRA within the 61 day time frame.

When doing these calculations, don’t forget to factor in any capital gains distributions from mutual funds and ETFs held in taxable accounts.

Tax-loss harvesting for clients with taxable holdings can be a good way to use investment losses to reduce their taxes. This makes the most sense if done in the context of managing the client’s investment strategy, such as part of the rebalancing process. While tax-loss harvesting is often a focus of year-end planning, this strategy can and should be used throughout the year. (For more, see: Present Your Clients With A Year-End Review.)