Optimizing tax loss harvesting / Crucial “blocking and tackling” for financial advisers

Chad Smith for Investment News writes:  Thanks to strong equity market returns over the past two years, investors have made significant progress in rebuilding their portfolios. Many clients, however, remain on edge as they wait for the “other shoe” to drop. Contrary to the first-blush reaction of many, this other shoe isn't the potential of continued gridlock in future months around our nation's debt ceiling — it's the impact of an ever-more-complex tax code.

Last January, the top capital gains tax rate increased from 15% to 20%, while a 3.8% investment income surtax kicked in for many investors as well. Those are just the federal taxes — depending on where they live, many clients are preparing themselves for another significant tax hit at the state level as well.

More than ever before, financial advisers possessing or having ready access to professional tax expertise can add value for their clients. This unique quality allows advisers to distinguish themselves by providing guidance that integrates both tax and investment solutions. For one clear example of this, look no further than the basic practice of tax loss harvesting. 

No doubt, the vast majority of advisers understand the concept that investors should look to sell the losers in their portfolio at the end of the year in order to offset gains from winners. In 2013, as many investors' portfolios have shifted away from their asset allocation targets due to gains in equity assets and losses in fixed income, harvesting losses in a careful and strategic manner will be especially crucial.

Without access to tax expertise, however, even this fundamental practice can be difficult for advisers to implement. Estimating capital gains and losses for every asset in each non-qualified account, for each client, and then executing the proper strategy to lock in the most favorable tax treatment is a time-consuming and complex process. For both advisers and their clients, however, the effort is clearly worth it: no investor can afford to lose out on tax savings that may amount to 30% or more of their capital gains when state and federal taxes are considered.

Capital gains are taxed differently depending on the holding period of your investment. The holding period is how long you have held an investment. A short-term holding period is typically one year or less, and a long-term holding period is usually more than one year. 

Short-term capital gains are taxed at ordinary income tax rates. In 2013, this ranged from 10% to 39.6%. The tax on long-term capital gains is typically less than ordinary tax rates. The long-term capital gains tax is either zero percent, 15% or 20% depending on your marginal tax bracket.
For advisers seeking to maximize tax benefits for their clients by harvesting losses in 2013, we suggest the following best practices:

1. Look for opportunities to maintain each client's overall investment strategy and asset allocation targets by substituting exchange-traded funds or indexed funds with similar objectives and holdings for the winners and losers being sold.

Advisers and clients often find themselves stymied in executing tax loss harvesting plans because they believe strongly in a given fund manager, or because selling a fund would reduce the client's exposure to certain assets or sectors. By shifting client assets into funds that are similar to those being sold, advisers can continue to participate in managers' strategies, while often maintaining very similar overall holdings.

In the ETF world, substituting one ETF for another without disrupting a client's strategies or asset allocations is even more straightforward.

2. Be aware of the wash sale rule, an Internal Revenue Service rule that prohibits a taxpayer from claiming a loss on the sale or trade of a security in a wash sale. The rule defines a wash sale as one that occurs when an individual sells or trades a security at a loss and within 30 days before or after this sale, buys a “substantially identical” stock or security, or acquires a contract or option to do so. A wash sale also results if an individual sells a security, and the spouse or a company controlled by the individual buys a substantially equivalent security.

In order to ensure that clients recognize losses of the same magnitude as their gains and achieve the strongest tax deferral outcomes in 2013, there is simply no substitute for a manual review process performed by an attentive adviser. For investors who will experience lower income next year, the right answer may be to hold off on selling 2013 winners altogether.

3. For clients with significant assets but whose income puts them in the 15% ordinary income tax bracket (below $72,500 for married taxpayers filing jointly or $36,250 for single filers), consider taking winners off the table even if the client does not have offsetting losses elsewhere. Taxpayers in the 15% bracket can sell appreciated stock at a 0% federal capital gains rate. Selling now may be the best way for such investors to ensure they benefit from the current tax treatment. Moreover, these clients can establish a stepped-up basis in similar assets by shifting their holdings from current winners into similar funds as mentioned above.
As we're seeing more each year, the rising complexity of the tax code and ongoing potential volatility in the capital markets are driving investors — particularly in the high-net-worth segment — to recognize the inherent value that comes from combining investment advice with in-depth guidance on the tax front. 

No matter how well a client's investment strategy performs, no investor can afford to lose out on the incremental returns that come from a properly-executed tax loss harvesting process. By committing the time to implement the best practices listed above, advisers can ensure that their clients are well-positioned to weather changes to the tax code both this year and in the future.