As we approach the midpoint of the calendar year, many investors will pause in between backyard BBQ’s and fireworks to evaluate how 2016 has treated their portfolio. Most will start and stop the evaluation by looking at their total return on a statement or smart device. We encourage you to look closer and see if your advisor has executed one of the most basic—and most overlooked—tax strategies, known as tax-loss harvesting.
Tax-loss harvesting is simple in concept, and involves selling investments, such as stocks, bonds and mutual funds, at a loss during the tax year. Why sell some of your losers? Because the realized losses that result can be used to offset both capital gains and income.
Here’s how it works: Let’s say you purchased a stock position for $25,000 a year ago, and its value has fallen to $22,000. You sell the position, “harvesting” the $3,000 loss. You can then use that loss to offset a current $3,000 capital gain. Through tax-loss harvesting, we can use realized losses to offset taxable gains, and then to reduce ordinary income, up to $3,000 per year. Any losses that you harvest above $3,000 can be carried forward to reduce gains or income in future years.
Tax-loss harvesting effectively unlocks losses to offset gains in other parts of your portfolio. That means less of your money goes to Uncle Sam, and you effectively earn a higher, after-tax return. Ultimately, it’s not how much money you make that matters, it’s how much of your money you keep that counts—and taxes can make a big difference. Following the tax-loss sale, the securities you’ve sold are replaced with similar ones in order to keep your portfolio configured to meet your investment objectives.
Tax-loss harvesting is not a new strategy. Financial advisors have been doing it for decades—but here is the issue, advisors typically only harvest losses once a year, in the fourth quarter. But thanks to technology, harvesting is now being automated. That’s very good news for investors, and here’s why:
Harvesting opportunities are created continually through the year, as markets temporarily decline. Human advisors don’t have the time or ability to take advantage of these myriad opportunities. Because they typically harvest just once a year, they take advantage of only a small portion of the loss-harvesting opportunities that are available—that costs investors money.
Consider that over the past 15 years, the S&P 500 Index has had negative quarterly returns 34% of the time. Of those negative quarters, 80% occurred in the first, second and third quarters. Remember that advisors typically rebalance once a year, in the fourth quarter. This conventional approach misses out on 80% of the loss harvesting opportunities within the year.1
But new developments in financial technology allow forward thinking advisors to change the game. This technology can identify and execute harvesting opportunities on a daily basis. Technology allows advisors to be ever-vigilant, never tiring and never missing an opportunity to realize a loss without changing your asset mix. The results can have a huge impact.
Most tax-loss harvesting technology automatically makes the sales and purchases that will provide the optimal tax benefit. It also automatically complies with the IRS’s “wash-sale” rule. The rule states that if you sell an investment at a loss and then reinvest the proceeds in the same, or substantially identical, asset within 30 days, the loss will not be allowed for tax purposes.
Tax-loss harvesting has always been a great concept for whittling down the size of your tax bill which advisors have historically struggled to implement on a frequent and timely basis. Now, thanks to technology, the advisor is able to effectively turn concept into reality. As the mid-summer heat increases to uncomfortable levels, take the time to ensure your advisor is using technology to decrease your tax bill.
1 S&P 500 Return data from Morningstar as of Q3, 2015
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