Recent market volatility may be testing many investors’ commitment to their financial plan. Seeing negative returns over short or medium time periods is never easy. This recent volatility is likely harder for many to stomach after a relatively low volatility over the prior 12 months and generally attractive returns over the last 10+ years. But as any good parent tries to teach their children, there’s always a way to find a positive out of a negative situation. As it pertains to this most recent bout of volatility, that silver lining is tax-loss harvesting.
What is tax-loss harvesting?
Remember that in the eyes of the Internal Revenue Service (IRS), it’s not a gain or a loss on an investment until you actually sell the asset – i.e. one has to actually sell the asset to realize the gain or loss.
Tax-loss harvesting is the process of realizing losses on investments that have a market value below its adjusted cost basis (meaning it’s worth less than what you paid). When done successfully, tax-loss harvesting allows you to create a tax asset: realized losses that can be used to offset against realized gains in the current year or carried forward into future years. Harvested losses – done properly – can be used to lower one’s tax bill across their portfolios.
The asymmetric relationship of gains/losses for mutual fund investors
For mutual fund investors, the IRS treats realized gains and losses differently. It’s an asymmetric relationship that changes how one views realized gains and realized (harvested) losses.
Here’s what you need to know:
- Realized gains:
- Distributed annually to shareholders.
- Distributions are reported on Form 1099 and flow to Form 1040.
- Even if you reinvest the distribution, it may be taxable (for taxable investors).
- Realized losses:
- Harvested losses in mutual funds belong to the mutual fund.
- Losses are not distributed to shareholder on the Form 1099 but stay on the balance sheet of the mutual fund.
- They are used to offset realized gains, but when? It could be in the current year, next year or carried forward indefinitely. The investor may not even be in the fund when the benefit is realized.
For mutual fund investors, it is almost heads you lose AND tails you lose. For gains, you pay taxes each year when realized and for harvested losses you may not see the benefit if the fund carries the loss forward and you are no longer in the fund.
How to get the best of both worlds
At Frontier Asset Management, we look to take advantage of the tax landscape and make it more of a heads you win and tails you win. How?
We use no proprietary products in our Strategies. Instead, we have most of the entire universe of investable products to consider in our Tax-Managed Strategies including active funds, passive funds, tax-managed funds and ETFs. This objectivity allows us to harvest losses at the fund level (sell one fund and move to a not substantially similar fund). We do not leave loss harvesting solely to the mutual fund company.
Consider the recent market volatility within emerging market equities, small cap equities and long-treasuries as examples. Due to Frontier’s arm’s length relationship with our investment offerings, we can completely sell out of a fund and move to a not substantially similar fund to realize (harvest) the loss. The investor is not out of the market during the process – instead, they’re fully invested. Those harvested losses belong to the investor that year or they can carry forward into future years to offset realized gains. The realized losses are theirs. When done properly, this can reduce tax bills, improve after-tax returns and increase the management investors have over their tax situation.
Additionally, Frontier is not averse to using tax-managed funds that are also loss harvesting within the fund as described earlier. We will not include a fund in our Strategies if it is only successful in deferring gains. The data also needs to show that the fund is additive in increasing after-tax returns. The Frontier process is not about avoiding taxes, but about looking to maximize after-tax returns.
This tax-loss harvesting exercise is also an opportunity to manage for risk in our Downside First Focus process. This purposeful reallocation across the Tax-Managed Strategies allows us to adjust weights and allocations to reflect market movements and forward-looking views on the market. This dynamic process is key in managing to our downside risk targets.
No one wants their investments to lose value, but recent market returns remind investors that holding positions at a loss is part of the experience for long-term investors in diversified portfolios.
A process that takes market volatility and creates tax assets for investors (truly for the investor – not just the fund) can make meaningful differences in after-tax returns. Frontier Asset Management has over 20 years of experience in managing client portfolios with a focus on managing downside risk and maximizing after-tax returns. It’s the Frontier way.
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