Recent market volatility has created some opportunities in markets, not just in buying the dip. Taxes are something that should be minimized where you can. Tax planning, tax-loss harvesting, and active portfolio engagement can make a difference to clients’ overall returns throughout the year. We continually look at and utilize multiple strategies to make your money work harder and smarter.
One strategy we use is tax-loss harvesting, an opportunity to reduce your taxable capital gains by selling an underperforming investment that has experienced losses. Illustrating our approach to things is the best way to help you understand the big picture concept of tax-loss harvesting.
Imagine a client with a $5 million taxable portfolio allocated equally between an equity strategy, a bond account, and a moderate allocation strategy. The markets get off to a bad start at the beginning of the year, much like in 2022. The equity strategy has losses of $100,000, the bond account has losses of $50,000, and the moderate allocation has losses of $120,000. In this scenario, we have a total of $270,000 losses. We assume the losses are harvested by the middle of the year. Then the accounts all rebound from their losses by the end of the year, and the total portfolio value returns to $5 million.
Imagine a second client who started the year off with the same $5 million investments. They have all the same strategies, account sizes, and holdings. The accounts declined until the middle of the year and then recouped all their losses. The two situations seem similar until April 15, the tax deadline. The difference between the clients is that Client A has a tax asset in the form of realized losses of $270,000, which can be used to offset current or future capital gains, and Client B does not.
Taxes are at the top of most people’s minds in the months leading up to tax filing time when the tax year has closed and at a tax year-end, looking to sell any positions at a loss. We think about taxes throughout the year, especially during volatile markets. We think about taxes constantly because capital losses can happen at any time, not just around the end of the year. Capital losses can offset gains realized in that same year, and any unused loss can be rolled over into future years. If you wait until the end of the year, the losses could swing back to gains, and you would lose a valuable asset. To capture the loss, we monitor our portfolios for capital losses regularly. One point to make early in the conversation is that assets must be in a taxable account to utilize tax-loss harvesting strategies. 401(k)s, IRAs, and other tax-deferred accounts are not eligible for tax loss harvesting.
You may find yourself thinking, how could a loss become an asset? When you harvest a capital loss, you can apply that loss to offset a capital gain, and you get to carry over any leftover loss for years after that. By continuously monitoring your portfolio, we can realize a loss, reinvest those funds, and keep a portfolio invested so that you can benefit when markets recover.
As portfolio managers, we balance client needs for capital appreciation, current income, tax efficiency, and other individual considerations. We understand that when markets are volatile, there is usually an increase in uncertainty. The last thing people want in volatile market conditions is to pay a large tax bill.
In addition to tax loss harvesting, there are numerous other tax considerations when investing in taxable monies. What you put in an account can make a difference. An exchanged traded fund (ETF) will usually be more tax-efficient than a comparable mutual fund, primarily due to how they are structured and pay out capital gains. Mutual funds typically have higher capital gains because they not only have portfolio transactions but they have to buy and sell shares to meet redemptions and new fund purchases.
Tax alpha maximizes after-tax returns in an investor’s account by optimizing available tax-saving strategies. We add tax alpha through loss harvesting, short-term gain deferral, and asset location prioritization. Within a taxable account, we will take short-term losses before they become a significant loss in the portfolio. We strive only to realize short-term gains if the risk of capital impairment is greater than the tax cost of taking a short-term gain. Our asset location preference is to use high tax cost securities in tax-deferred accounts. Securities with a high tax cost include actively managed mutual funds, real estate investment trusts (REITs), taxable bonds, and more.
Spectrum Wealth Management, LLC is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. Additional information about Spectrum’s investment advisory services is found in Form ADV Part 2, which is available upon request. The information presented is for educational and illustrative purposes only and does not constitute tax, legal, or investment advice. Tax and legal counsel should be engaged before taking any action. The opinions expressed and material provided are for general information and should not be considered a solicitation for purchasing or selling any security.