The false assumption that all gains are good and any losses are bad can cost retail investors when it comes time to pay Uncle Sam.
In an investment world driven by up-to-the-millisecond headlines about stock values and the vast earnings of the most valuable global companies, financial advisors and tax professionals can forgive their clients or prospective customers for failing to keep the full impact of capital gains in mind. Toward the end of each year, though, they could delight those clients with tax savings based on avoiding a fund distribution or offsetting gains with loss harvesting — a reminder that sometimes in investing, as in life, a setback is often a blessing.
For financial planners and tax professionals, those valuable losses of up to $3,000 per year with the ability to carry anything above that level into a future year could play out in any month or season. And giant wealth and asset management firms like JPMorgan Chase and Morgan Stanley, as well as third-party financial technology companies, are rolling out solutions enabling advisors to tap into loss-harvesting and monitor potential distributions without the burdensome task of checking all the time for potential risks of capital gains or possible offsetting declines.
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The fourth quarter marks "a great time to look at tax-loss harvesting opportunities" because, "if we've realized a lot of gains, we can now try and identify opportunities to offset them," said Adrienne Davis, a financial planner with Philadelphia-based Zenith Wealth Partners. Rather than paying taxes on their earnings, a client could be breaking even on their returns at the end of the year and putting more losses in reserve for the future "if they anticipate having to sell a large amount of stocks," she said in an email.
"When communicating with clients, we layer tax planning into every facet of the financial planning process," Davis said. "For our W-2 clients, they don't have a lot of flexibility in deductions they can take if they don't have rental properties or own a business. We then have to look at tax-loss harvesting and/or itemized deductions."
Besides the annual limits on the deduction for investment losses and "wash-sale" rules prohibiting clients from buying essentially identical securities 30 days before or after the trade, advisors face time restrictions when seeking to carry out their harvesting strategy in the midst of a "short period of elevated volatility" such as March 2020 or the beginning of August 2024, according to Jeremy Milleson, director of investment strategy with Morgan Stanley-owned direct indexing portfolio management firm Parametric Portfolio Associates.
"You don't know when you're going to have those loss-harvesting opportunities. If you are just reviewing them on a quarterly basis or an annual basis you might be missing the opportunity," Milleson said in an interview. "It is important to have that systematic, rules-based approach, and where technology comes in is really making that more available to clients. It takes that work off your plate. You're able to build a portfolio that has those exposures that you're looking for."
Earlier this year, competitor J.P. Morgan Asset Management launched a "Heatmap Analysis" tool aimed at simplifying the search for losses and identifying capital gains distributions across 5,000 mutual funds and ETFs, according to Stephen Kaplan, the firm's head of customized managed account solutions. The latter area brings a slightly higher layer of complication based on the fact that those gains flow to the fund managers but also to investors, Kaplan noted.
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Say, for example, that a planner or tax professional notices that there is a large estimated gains distribution for holders of a particular mutual fund on a certain date — which could deliver a substantial tax hit for some investors.
"If you sell out before, then you wont get that capital gains distribution, so you avoid that [distribution]. However you may be taking a gain in your actual investment," Kaplan said. "One doesn't necessarily offset the other. They're two different things."
The individual clients' circumstances may affect the process as well. If they have a large concentration of their holdings in a particular equity or restricted stock units, the loss-harvesting could prove especially beneficial, Davis pointed out.
"The mindset should be to capitalize on market downturns and sell out of stocks that you either no longer believe in or that you've been wanting to offload," she said. "This is also applicable to our clients with RSUs. If the company stock is underperforming, they could potentially sell out of those shares, taking the loss on paper, and reinvest into stocks/bonds/ETFs that have greater opportunity for appreciation."
For advisors using increasingly popular direct-indexing strategies that seek to track a benchmark such as the S&P 500 through holdings of individual stocks, deciding the timing and extent of the weighting in the portfolio for, say, the Magnificent Seven tech stocks is "one of the most important decisions," according to Milleson. Many advisors "probably struggle" figuring out whether those losses will be a short-term blip and answering the questions of how closely to stick to a benchmark and balancing pretax gains in the long run against harvesting this year.
"A risk perspective becomes very important," Milleson said. "For a lot of clients, there's an emotional attachment to a lot of these names as well."
READ MORE: How to unlock tax savings in incoming client portfolios
In the case of clients with mutual fund holdings in taxable accounts, they should take special care to watch out for distributions, Kaplan noted. And in every situation, advisors can provide "a lot of education that would be really helpful for the broader industry," he said.
"There are gains that get accumulated, and those gains get passed onto the client. If you're in the fund, it doesn't matter if you've been in that fund for a day or if you've been in that fund for years," he added. "Ultimately, every client is going to be having a different scenario that they should be taking into account."
