Help your clients harness the power of tax-loss harvesting

As the year draws to a close, it's crucial for financial advisors to engage their clients in discussions about year-end tax strategies to help them make informed decisions, minimize tax impacts, and potentially mitigate unexpected tax exposures.

Tax-loss harvesting is one such strategy that, when employed correctly, can potentially provide significant tax benefits. However, explaining the intricacies of tax-loss harvesting to clients can be challenging. Here are some best practices for discussing tax-loss harvesting with your clients.

1. Start with the basics

Before delving into the complexities, provide your clients with a clear, straightforward explanation of tax-loss harvesting. Explain that tax-loss harvesting involves strategically selling securities at a loss to offset taxable gains elsewhere in their portfolio, including those from sales of investments or capital gain distributions from mutual funds or exchange-traded funds (ETFs). By doing so, investors can use tax-loss harvesting to reduce their tax liability for the year, thus deferring tax payments and allowing their assets to stay invested and potentially grow over time.

2. Focus on the fundamentals

While tax-loss harvesting can save substantial amounts in taxes, it should not derail your client’s overall investment strategy. A comprehensive evaluation of each client’s portfolio is essential to ensure that any tax-motivated decisions do not compromise the portfolio's long-term goals, asset allocation, and risk exposure.

“Taxes should not be the first thing you think about when choosing what to buy and sell. Don’t let tax reduction techniques derail your overall investment strategy.”

– Roger Young, CFP®, Thought Leadership Director, T. Rowe Price

3. Help your clients understand the Wash Sale Rule

Explain how the IRS’s wash sale rule prevents investors from claiming a tax-deductible loss on a security if they repurchase the same or a substantially identical security within 30 days before or after the sale. You and your clients need to be especially cautious about this rule to avoid inadvertently disqualifying a sale's tax benefits.

4. Set realistic expectations

It’s important to manage your client’s expectations about tax-loss harvesting. Make them aware that this strategy is most effective in volatile markets, where opportunities to harvest losses are more prevalent. And convey that while reinvestment in similar securities mitigates market risk, it doesn't entirely eliminate it. There’s always a chance that the market conditions impacting the initial investment could also impact the reinvestment.

5. Tailor your discussion to individual clients

Clients have unique financial situations and risk tolerances so it’s important to customize your conversation. Highlight how their specific tax bracket influences the effectiveness of tax-loss harvesting—higher tax brackets stand to benefit more from the strategy. Discuss how their long-term financial goals align with the short-term actions required by tax-loss harvesting and consider their personal risk preferences and comfort with the idea of realizing losses and reinvesting shortly thereafter.

6. Use visual aids to illustrate the effects of tax loss harvesting

Consider using visual aids to enhance a client’s understanding of tax-loss harvesting, including providing hypothetical examples that detail the before-and-after of a portfolio where tax-loss harvesting was applied. In addition, it’s important to provide regular updates and reporting to show the client’s progress and the benefits gained when a tax-loss harvesting strategy has been put in place.

The tax benefits of tax loss harvesting

Consider two hypothetical clients, John and Jane, who each have realized net total long-term capital gains of $50,000 and short-term gains of $10,000 in the current tax year. Both are in the 24% tax bracket for ordinary income and short-term capital gains, and a 15% bracket for long-term capital gains. John doesn’t take advantage of tax-loss harvesting and ends up with a tax liability of $9,900. In contrast, Jane harvests $5,000 in short-term losses and $15,000 in long-term losses, reducing her tax liability to $6,450. This $3,450 savings can be reinvested, providing further growth opportunities.

The fourth quarter is a pivotal time for tax-loss harvesting for several reasons:

• Year-end tax planning—By this time, you have a clearer view of your client’s tax situation, including realized gains from earlier in the year and estimated year-end distributions from mutual funds and ETFs.
• Dividend and capital gains distributions—Most mutual funds and ETFs distribute dividends and capital gains in the fourth quarter. Selling underperforming investments before these distributions take place can prevent your client from owing taxes on the gains, which might otherwise be reinvested at a higher cost basis.
• Last-minute adjustments—The fourth quarter provides an opportunity to make any last-minute adjustments before the tax year closes. This helps to ensure that clients benefit from tax-loss harvesting within the same tax year, providing immediate tax savings and potential for reinvestment.

Many assume tax-loss harvesting is strictly a year-end activity, but opportunities can arise throughout the year. Regularly monitoring portfolios to identify material losses, typically 10% or more, can make the effort worthwhile.

Tax-loss harvesting is a powerful tool for financial advisors aiming to enhance their clients' after-tax investment returns. By explaining the fundamentals, highlighting the benefits, and setting realistic expectations, you can demystify this strategy and empower your clients to make informed decisions. Share the insight How tax loss harvesting can help improve your investment returns with your clients to help them understand how strategically selling holdings at a loss can help reduce their portfolio's tax liability. A well-informed client is more likely to appreciate and engage with tax-loss harvesting, recognizing its potential to help fulfill their long-term financial goals.