Tax harvesting, to use a term in the wealth management industry, has limited use for high net worth investors over time, the author argues.

The changed tax landscape in the US following last December’s package of measures has seen much attention devoted to moves such as doubling of estate tax exemptions and the drastic cut to corporate tax rates. Other features of the tax code are still coming to light. And even before the latest adjustments, an issue that arose for investors is what is sometimes called “tax harvesting”. (This publication has interviewed practitioners about this issue here and here.) By selectively selling specific investments, advisors can realize gains or losses in an account. Selling investments in a client's taxable portfolio that have dropped in value – i.e., “harvesting” those losses – will generate losses that can be used to offset gains the client’s portfolio has realized. Alternatively, advisors can help clients realize gains in their taxable portfolios to offset losses from other investments. Especially during volatile markets, tax harvesting can provide an effective way to use losses to enhance after-tax portfolio performance.

But there are many complexities and potential pitfalls involved in such strategies. To discuss these, Mark Hoffman, chief executive of the firm LifeYield, argues that such ploys have their limitations.

The editors of this news service are pleased to share these views with readers and invite responses. Email tom.burroughes@wealthbriefing.com

Over $1.7 trillion in capital gains tax receipts will be collected over the next 10 years from $21 trillion in US household taxable investment assets, according to the Congressional Budget Office. While the government appreciates investor largesse, there are much better ways for advisors to help clients minimize taxes and increase after-tax returns and income through asset location by using currently available technology.

When clients seek to reduce investment taxes to achieve retirement goals, the common response is for advisors to talk about tax-loss harvesting. Sadly, this ignores the over $15 trillion sitting in tax-deferred US retirement accounts. The typical household owns 5-6 accounts split between taxable, tax-deferred and tax-free accounts, often purchased from 2-3 advisors.  Looking at investments in various accounts without any coordination hurts investors. This is amateur hour and does not support a goals-based wealth management plan. A coordinated, tax-smart asset location implementation plan can help improve after-tax outcomes by 33 per cent.

Tax-loss harvesting is a start but only a marginal solution. It is the exercise of selling an asset in a taxable account that has less value today than when it was originally purchased. The loss can then be netted with gains and up to $3,000 can be used to shelter income. While helpful, it doesn’t consider an almost equal amount of retirement assets are held in qualified retirement accounts, nor does tax-loss harvesting create lasting tax efficiencies over time.  

Ultimately, the solution shouldn’t begin at tax-loss harvesting, rather, it needs to be identified at the outset when advisors work with their clients to recommend how to organize each account in the household to maximize the various tax treatments of those accounts.

Retirement goals are holistic, multi-account challenges; keeping retirement accounts and their incredibly powerful unique feature of sheltering taxes during accumulation separate from reducing investment taxes in taxable accounts misses the opportunity for advisors to provide an optimal outcome.

As a case in point, a popular rule-of-thumb used by advisors for clients with multiple account investments is:

-- Place appreciating assets in the taxable account and employ tax-loss harvesting; and

-- Place ordinary income producing assets and/or high return, high turnover assets in the tax-deferred accounts so the income is not taxed. 
 

This sounds simple, but as Einstein once said, “Everything should be made as simple as possible, but not simpler.”

Taking a more holistic approach –focusing on achieving the largest after-tax balance across all accounts – can change the location of assets dramatically. Historically, the challenge for advisers has been that without technology, asset location strategies are difficult to develop and execute. In addition, without a complete, holistic picture of an investor’s entire portfolio, creating a plan capable of achieving real tax benefits is impossible. However, with the right tools and client information, advisers can provide a comprehensive, tax-aware view of a client’s entire portfolio, so they make and keep more money to achieve their financial goals.

Let’s consider an example where we optimize the location of the assets within the account types those assets are held, otherwise known as optimal asset location: 

An advisor has a client with $1 million in investment accounts split 50/50 in each of taxable and tax-deferred accounts. Their income tax rate is 33 per cent and long-term capital gains rate is 20 per cent.  The asset allocation for the total portfolio is 60 per cent equity and 40 per cent fixed income with the taxable account holding a tax-managed Large Cap Fund and the tax-deferred account holding 80 per cent US Aggregate Bond ETF and 20 per cent Active Equity Fund. Both equity funds track the S&P 500 Index and the bond fund tracks the Barclays US aggregate bond index.

The “rule-of-thumb” organization of assets within the accounts generates a 6.04 per cent after-tax return and has a balance of $1,798,038 after ten years. However, the most tax-efficient organization – or, tax-smart asset location – of the portfolio, substituting a municipal bonds for the taxable bond allocation and putting more of the active equities in the tax-deferred account, yields a 7.36 per cent after-tax return for a balance of $2,033,683 after ten years – a $235,646 in potential benefit difference! While this may seem counter intuitive and the client may take a capital gain hit to shift where assets are held, the long term effects would result in a six-figure savings in taxes. 

Even if the equity substitution is disallowed, there is still a $21K benefit for substituting just the bonds thereby eliminating much of the need to worry about trading for losses in the taxable accounts. Investment taxes paid for the worst organization of the assets within the accounts average over $25,000 per year versus less than $650 for the best; the optimal outcome even paid 79 per cent less in taxes than the current rule-of-thumb placement.

Tax-loss harvesting is an adequate single account tax mitigation strategy. However, the benefits of tax-loss harvesting for clients in mid- to high-tax brackets who have losses, are mostly dwarfed by the value of tax-smart asset location –locating tax-efficient assets and tax-inefficient assets appropriately through time. Not only does this approach save investors’ money, it is becoming the cornerstone of goals-based wealth management as taxes are the largest expense during retirement.

Rather than viewing taxes as unavoidable cost of saving for retirement, advisors can leverage asset location strategies as an opportunity to add value and manage accounts holistically for their clients.