Perspective : Top five tax-loss harvesting mistakes to avoid

< Back

The recent volatility in equity and fixed income markets has led to a proliferation of stories about the benefits of tax-loss harvesting. If you had a nickel for every story out there mentioning “turning lemons into lemonade” or “silver lining of market pullbacks” or “upside of downside markets,” you could likely retire rich. Admittedly, I recently wrote a blog using the “silver lining” line. Why? Because it is true!

What is tax-loss harvesting? 

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, indefinitely. Harvested losses – done properly – can be used to lower one’s tax bill across their portfolios.

What could go wrong? 

1. Is the juice worth the squeeze?

Tax-loss harvesting is not a means to an end. Higher after-tax wealth is the end goal, not simply tax-loss harvesting because the market is down. You need a process to critically analyze each tax-loss harvesting opportunity.

a. What are the trading costs associated with the potential transaction costs?
b. Do you have an equal or more compelling investment to transition to?
c. Do you know your client’s tax situation? Does their marginal tax rate even warrant loss-harvesting?

Don’t tax-loss harvest just for the sake of it. You need a process that ensures the efforts are additive to after-tax returns.

2. Don’t be washed out

Violating the wash-sale rule may cause you to lose what you thought was a harvested loss. How? The wash-sale rule is when you buy the same or “substantially identical” security within 30 days of the day of sale. Why the quote marks around “substantially identical”? The IRS is purposefully vague on how this is defined, and they are the final arbiter. When in doubt, consult a tax professional.

Note that you cannot avoid the wash-sale rule if you sell a security in a taxable account and purchase the same (or substantially identical) security in your 401k. This trade would disallow the tax asset you were looking to create.

3. Don’t get lost

Tracking error: Too often, investors are so intrigued with the idea of creating a tax asset through tax-loss harvesting, that after the tax-loss harvesting trade, the new portfolio does not represent the target portfolio. This different portfolio may lead to increased tracking error from the target portfolio. Does this new portfolio increase unintended biases or positions. Do you fully appreciate what the transaction does to the portfolio’s risk profile? Because of the wash-sale rule, you may have made certain investment compromises to achieve the recognized losses.

If harvesting losses creates a sub-optimal portfolio, is it really the correct approach? Again, don’t wander too far from the path and let the tracking error deviate too far from your target.

A related challenge is holding the proceeds in cash for 30 days to wait out the wash-sale rule instead of investing directly. Is holding cash part of the target portfolio? If markets are trending down, this may work. But making a market timing decision can be quite challenging.  Don’t let holding cash be a drag.

4. You snooze, you lose

As I wrote in a prior blog, it’s only a loss if it’s realized (you actually make the trade). Many advisors look for tax-loss harvesting opportunities at year-end. That might fit one’s operational calendar, but the market moves independently. Historically*, markets have – on average higher monthly returns in November and December – the very time when many look for tax-loss harvesting opportunities. And recall what markets did during the sell-off during the onset of COVID-19 in March of 2020. Equity markets rallied so quickly, the tax-loss harvesting opportunity was gone before many had the opportunity to take advantage of the pullback. See the exhibit below.

5. Fortune favors the brave

Contrary to Matt Damon’s infamous quote in his Super Bowl crypto commercial, we believe fortune does favor the brave in terms of executing successful tax-loss harvesting trades in taxable accounts. We’ve listed several challenges around tax-loss harvesting, but it’s not a knock against the process.

When done properly with thoughtful analysis, successful tax-loss harvesting can lead to improved after-tax wealth for investors. The biggest mistake is to not take the entire process into consideration – and when beneficial – pull the trigger and execute the desired trades.

Frontier’s approach

At Frontier Asset Management, we’ve been managing investors’ taxable strategies for more than 20 years. During this time, we’ve learned a lot about working on behalf of investors to actively manage portfolios seeking to maximize after-tax returns.

We have a 14-member investment team that includes nine CFA’s representing decades of combined trading experience and a time-tested process around tax-loss harvesting that takes all the previously mentioned pitfalls into consideration. Our forward-looking process uses tax-loss harvesting as an opportunity to reposition our strategies to reflect our views on the market and helps to manage to our Downside First Focus.

An example:

In May of this year within our Tax-Managed Balanced Strategy, we liquidated a position in the Vanguard Tax-Managed Balanced Fund[1]. This remains a compelling fund for taxable accounts and includes allocations to both U.S. equities and passively managed municipal bonds in a single fund. But due to market volatility, the liquidation of this fund (and harvested loss for investors in a loss position) allowed us to deploy those proceeds into different passive municipal bond exposure and an active U.S. equity fund looking to take advantage of the recent sell off in growth names. The trade resulted in similar (but substantially different) municipal bond exposure and an active equity manager and created a tax asset for many investors.

Putting it together

Given the market volatility of late, you will undoubtedly see and hear more about tax-loss harvesting between now and year-end. Remember, this volatility has impacted both equity and fixed income investments. Consider the entire portfolio – not just equities. There are many ways to approach tax-loss harvesting incorrectly, but when done properly, it can materially improve after-tax returns for investors. And yes, it puts the silver lining, the lemonade and upside to tax-smart investing for the brave (even more nickels).

 

The views expressed represent the opinion of Frontier. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Frontier believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and the Frontier’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in equity securities involves risks, including the potential loss of principal. Past performance is not indicative of future results. Exclusive reliance on the information herein is not advised. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal, investment or tax advice.

Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types of securities and no investment decision should be made based solely on information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for an s investor’s financial situation or risk tolerance. Diversification and asset allocation do not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before investing, consider investment objectives, risks, fees and expenses. Frontier may modify its process, opinions and assumptions at any time without notice as data is analyzed.

Exclusive reliance on the information herein is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell any securities, commodities, treasuries or financial instruments of any kind. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal, investment or tax advice.

Frontier Asset Management is a registered investment adviser with the U.S. Securities and Exchange Commission; however, such registration does not imply a certain level of skill or training and no inference to the contrary should be made.  Additional information about Frontier and its investment adviser representatives is available on the SEC’s website at www.adviserinfo.sec.gov.

Frontier’s ADV Brochure and Form CRS are available at no charge by request at info@frontierasset.com or 307.673.5675 and are available on our website www.frontierasset.com. They include important disclosures and should be read carefully.

Frontier does not provide tax advice. Please consult with a CPA for recommendations pertaining to individual circumstances.

For the Mutual Funds mentioned herein, a complete description of their investment objectives, along with details of the risks and fees involved is contained in their respective prospectus and statement of additional information, which is available on their websites and should be read fully.

It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the mentioned securities herein. Upon request Frontier will provide the complete list of recommended funds during the period.

* “Stock Market Indicators: Historical Monthly & Annual Returns”, Dr. Edward Yardeni and Joe Abbott, June 1, 2022 https://www.yardeni.com/pub/stmktreturns.pdf

[1] It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the mentioned securities herein.

062822DWM062823

Related Content

Blogs & Articles