In a down market, do more than just tax loss harvesting for your clients

In a year like this one, many investors will be looking to use tax harvesting to squeeze some good from generally dismal returns.

I have mixed feelings about tax harvesting that I’ll explain. In short:

• It’s limited in its scope to save taxes.
• It’s acknowledging that some of your investments weren’t, perhaps, wise.
• It’s not nearly as effective for long-term tax alpha as asset location.

Don’t stop with tax harvesting

After you’ve balanced gains against losses, you can only deduct up to $3,000 in capital gains from your tax bill in one year, with the option to spread losses over up to three tax years. When tax-loss harvesting, it’s incumbent on an advisor to take a multi-account approach that examines the potential for harvesting gains and losses across all nonqualified accounts in a household when spouses file jointly.

Then, advisors need to follow up on any tax harvesting by multi-account rebalancing to ensure that the investor’s (or investors’) portfolio remains true to their risk tolerance, timeline, and investment and retirement goals.

I also recommend advisors with clients who are inclined toward philanthropy to let them know about opportunities to sell investments that have increased in value to create a charitable gift account. The donation is a tax deduction, and they don’t pay capital gains taxes. Or they can donate the investments outright to a favorite charitable organization.

Investors tend to ask about tax harvesting as the end of the tax year approaches. But I recommend that advisors use tax harvesting throughout the year. They could potentially save their clients more.

If tax harvesting is lemonade, remember that it still came from lemons

Let’s acknowledge that if you’re harvesting losses, you’re, well, harvesting losses. And the ability to harvest losses tends to dwindle over time when portfolios are well managed and taking advantage of other ways to limit investors’ taxes. Start with asset location, the single most effective way to achieve tax alpha for your clients.

Asset location describes the practice of placing investments in brokerage or tax-qualified accounts to minimize tax exposure. For example, investors place untaxed municipal bonds in taxable accounts and mutual funds with high turnovers in tax-advantaged accounts like individual retirement accounts (IRAs) or 401(k)s.

When you apply asset location to portfolio management, opportunities for tax harvesting decline over time, but after-tax returns are much higher. Clients get to keep more of what they’ve saved and invested.

Use this opportunity to pull clients back from obsessing over investing

The rumbling (or should I say, “crumbling”?) on Wall Street this year presents advisors with an opportunity to drill their clients on what time has proven to be the best strategy for success:

• Invest for the long term in a diversified portfolio of stocks, bonds and low-cost mutual funds and exchange-traded funds (ETFs).
• Maximize the benefits provided by tax-qualified accounts, including 401(k)s, IRAs, Roth IRAs and health savings accounts (HSAs).
• Periodically rebalance to stay true to an investor’s risk tolerance, timeline and goals.

And please, advise your clients that when they are investing for the long term, they don’t need to – and shouldn’t – be checking CNBC or Bloomberg or their account values daily. Long-term investing demands patience and, if necessary, finding an activity to replace stock trading. A long walk outdoors without devices is always a good choice.

LifeYield is a technology provider specializing in software for tax-efficient investing and tax-smart retirement income planning.