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Tax Planning Is a Year-Round Effort

With today’s technology, there’s no excuse for waiting until year-end.

Sheryl Rowling, 12/15/2016

Tax-savvy investment managers try to do right by their clients at year-end. At the top of the list is tax-loss harvesting for clients in high tax brackets. For clients in low tax brackets, advisors will look to harvest tax gains. While true that these tactics are better than nothing, there is much more to optimal tax planning. I will address best strategies for tax-loss harvesting, potentially superior alternatives to tax-gain harvesting, and capital-gains distribution avoidance.

Not Just for Year-End
Why is it that most advisors harvest losses only at the end of the year? The primary reason I hear is that tax-loss harvesting is too time consuming to pursue throughout the year. Yet if advisors sincerely believed that opportunistic loss harvesting was beneficial, they would find a means to make the process easier—through automation or simplification.

So, why is tax-loss harvesting such a big deal? Investors universally dislike paying taxes each year. Tax-loss harvesting can lower current-year taxes as well as potentially lead to more permanent savings down the road. Essentially, tax-loss harvesting involves selling shares at a loss solely for tax purposes—and replacing the sold positions with something similar, but not “substantially similar”—in order to remain fully invested. (Wash-sale rules disallow the tax loss if the same or “substantially similar” security is purchased within 30 days.)

Although recognizing accumulated losses cuts taxes in the year of sale, the tax basis of the remaining (replacement) securities is lower. In other words, tax-loss harvesting just postpones tax. But is this really true? Any appreciated securities owned at death receive a basis step-up to fair market value. This means that ongoing postponement of gain recognition can lead to permanent tax avoidance.

This is a very significant factor in investment management. The more investors can avoid triggering taxable gains during their lifetimes, the less tax will ultimately be paid. Unfortunately, it is difficult to completely avoid recognizing gains. Gains are captured for various reasons, including:

- Sales to generate cash.
- Sales for rebalancing.
- Sales to change investment strategy.
- Capital-gains distributions.

This is where tax losses can help. Capital losses can offset current-year gains and up to $3,000 per year of other income. Losses in excess of that can be carried forward indefinitely. By taking advantage of periodic tax-loss harvesting opportunities, advisors can create a loss “pool” that can be used to offset current-year gains, and potentially to offset future gains as well. More losses mean more immunization against gain recognition. And that is the ultimate goal—to minimize or eliminate gain recognition. Harvesting losses solely at year-end is just not enough.

Because the market, financial sectors, and specific securities ebb and flow, the potential for loss sales can occur throughout the year. By going after these losses, an advisor can generate annual net losses in excess of taxable gains—even when portfolio performance is positive. Is this enough to convince advisors that opportunistic tax-loss harvesting is beneficial? If not, consider the fact that robo-advisors are offering ongoing tax-loss harvesting as part of their value proposition.

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