Advisors can provide more holistic wealth management services by managing clients’ tax liabilities using tax-loss harvesting and wash-sale optimization. These two approaches help to minimize client tax liabilities on anticipated or realized gains, and also offer opportunities to generate “tax alpha” and reduce clients’ overall tax bill at the end of the year.
Offsetting investment gains with losses is, of course, a well-established practice among investors. However, by deploying technology that spans across a client’s entire portfolio, advisors are able to take full advantage of shifts in asset value and deliver tax-optimized portfolio management efficiently and cost effectively.
The promise of tax-loss harvesting
Academic research has shown that tax-loss harvesting can have a substantial impact on investment returns. Researchers at MIT and Chapman University have calculated that tax-loss harvesting yielded nearly 1.1% in surplus annual return from 1926 to 2018. Similarly, recent research from Columbia Business School professor and investment officer Harry Mamaysky estimates “alpha” from tax-loss harvesting between 30 and 65 basis points annually, depending on the design of the models used in estimates, with most of the benefits accruing in the first few implementation years of the strategy.
Tax-loss harvesting involves selling assets at a loss to offset capital gains within a current tax year. The market volatility of recent years has made tax-loss harvesting especially appealing, when losses present considerable opportunities to offset gains elsewhere in a portfolio. However, to take full advantage of gains and losses, advisors need to master the complexity of both client holdings and tax rules throughout the investment process.
Advisors also need to apply this mastery of portfolios and tax rules quickly and efficiently for a large number of clients. Failure to do so runs the risk of capital gains taxes and fees eating into returns and minimizing overall portfolio efficiency. Successful tax-loss harvesting provides a high-value tax benefit to clients, who increasingly have come to expect this level of service from their advisors while remaining well positioned to capture market upside.
Many advisors are moving toward “householding” for their clients’ portfolios to optimize tax efficiency. Householding involves reviewing risk exposures at a holistic level across all of a client’s accounts and viewing the overall portfolio as a “household” composed of many individual investment accounts (e.g., several separate brokerage accounts, IRAs, and other investment vehicles). Householding structures allow advisors to optimize the location of assets more easily in the right accounts to avoid short-term capital gains and save on taxes. Optimizing the location of assets in various types of accounts can significantly reduce the tax impact on a portfolio. Location optimization can help advisors achieve both temporary and long-term tax savings for their clients. One successful method is establishing capital gains limits, which can help control clients’ annual tax burdens by automatically setting budgets for different gains based on dollar values or as a percentage of the overall portfolio.
Benefits of tax-loss harvesting can be furthered by regularly rebalancing client portfolios to create fresh tax “lots,” which are records of the acquisition or purchase of a security. Each acquisition on a different date or for a different price constitutes a new tax lot. Advisors use these to ensure clients eventually sell the right bundle or lot of a depreciated security at the lowest possible price, thereby reducing their overall taxable burden.
Solutions like intelliflo redblack allow for automated rebalancing of client portfolios, making tax efficiency part of an advisory business’ everyday operation, allowing for advisors to focus on higher-value tasks like spending time with their clients and practice development. The solution also applies wash-sale rules across the household portfolio to optimize tax efficiency and operate within compliance restrictions.
Optimizing for wash-sale rules
Awareness of wash sales – a rule whereby tax losses are prohibited on sales at a loss when the same security is purchased 30 days before or after the original sale – is instrumental for strengthening tax planning and cash management strategies. New technologies can aid in effective tax-efficient investing and account for discrepancies like wash sales before they become a burden to clients, their advisors, or tax professionals.
Wash sales can quickly become significant in a client’s portfolio, as they limit the ability to claim capital losses, which are often used to offset gains elsewhere in the portfolio and reduce overall taxable income. The loss from a wash sale often cannot be immediately deducted – a client might have to wait 30 days until they can claim such a loss, at which time the client already incurs the tax. Instead, the disallowed loss is added to the original cost basis of the security, deferring the ability to claim the loss until it is sold outside of the 30-day window.
The ability to account for tax implications like wash sales and harvesting for tax losses make substantial differences in a portfolio’s total return and a client’s tax liability. The challenge for advisors is tracking and trading multiple securities at the lot level and replacing them with the correct substitutes while remaining inside the confines of the investment policy. This process is complex on the individual level and can quickly become burdensome when households and multiple accounts across different portfolios require specialized attention to ensure tax optimization.
Rebalancing platforms allow advisors to quickly harvest tax gains or losses and utilize securities to both maintain active market exposure while avoiding potential wash sales. intelliflo redblack’s wash sale feature ensures accurate, real-time wash sale detection across all accounts for a family or taxpayer including SMAs (separately managed accounts) and partially owned accounts.
Traditional methods often rely on manual checking of wash sale rules, and even automated checking can sometimes be limited to single accounts at a time. Adjusting the cost basis of a wash sale can be time-consuming, but by leveraging specialized technology that handles wash sale logic from the beginning allows advisory businesses to focus on their clients and business growth.
intelliflo redblack’s wash sale feature detects wash sale opportunities across accounts even when rebalancing multiple individual accounts as part of a rebalancing or trading session. This ensures holistic views of a client portfolio and minimizes the risk of wash sales eating into investment gains while staying compliant and tax efficient.
Ensuring tax management during the busy season
The end of the year can be a busy time for advisors, as they close out the current tax year and prepare investment and tax plans for the year ahead. As advisors approach the fall season, they would be wise to take advantage of technology that can aid in optimizing efficient tax practices like tax-loss harvesting and wash sale rules. In the absence of such technology, tax-loss harvesting and wash sale strategies are time-consuming and often error prone. Making tax efficiency a priority in end-of-year financial plans can help advisors streamline all their households simultaneously and focus on growing and maintaining their advisory businesses.
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