On Tax Day, Will You Be A Hero Or A Goat?

Instead Of Year-End Tax Loss Harvesting, Look To Year-Round Harvesting And Gains Deferral
Gerard Michael, President, Smartleaf
Gerard Michael, President, Smartleaf

Instead Of Year-End Tax Loss Harvesting, Look To Year-Round Harvesting And Gains Deferral

Tax day – April 15 – is approaching. In the eyes of your clients, will you be a hero or a goat? If you can demonstrate that you saved or deferred more in taxes than you charged in fees, you’ll probably be OK. If not, you may wish to up your game.

How? Let’s start with loss harvesting. If all you did was loss harvest at year end, you’re doing it wrong and likely underserving your clients. And you’re almost surely spending too much time on it. Furthermore, you miss the opportunity to loss harvest during mid-year dips. This matters – a lot. We estimate that year-round loss harvesting is, on average, 50% to 100% more effective than year-end loss harvesting. More precisely, it’s about 50% more effective in down and flat markets and twice as effective in up markets.

The only reason year-round tax loss harvesting isn’t more common is that, for many firms, loss harvesting is still primarily manual. For most clients, advisors simply don’t have the ability to do anything more than loss harvest at year end. It doesn’t have to be this way. Loss harvesting can be almost entirely automated. There are simply no practical barriers to providing every taxable client with expert year-round tax loss harvesting.

The Twist

Loss harvesting is great, but there’s a twist: It’s not the most important component of tax management. That honor belongs to risk-sensitive gains deferral. For many, this is shocking, like learning that Sherlock Holmes has a smarter older brother (Mycroft Holmes).

By quantifying the relative importance of gains deferral and loss harvesting, we estimate that roughly three quarters of taxes saved or deferred came from gains deferral, compared to roughly one quarter from loss harvesting.

We estimate that roughly three quarters of taxes saved or deferred came from gains deferral, compared to roughly one quarter from loss harvesting.

What Is Gains Deferral?

Gains deferral is the act of holding a position that, but for tax considerations, you would otherwise sell. It sounds simple. After all, how hard is it to not sell something? But there’s more going on than just refraining from a sale. The challenge of gains deferral is to avoid selling appreciated positions while still ending up with the portfolio you want.

The downside of holding onto a position for tax reasons is that you’re left owning an excess in the position, which leaves you exposed to a particular stock’s performance more than desired. The key to competent risk-sensitive gains deferral is controlling the risk from this exposure.

Why Is Gains Deferral More Valuable Than Loss Harvesting?

In a portfolio that is properly managed for taxes, over time you will get fewer loss harvesting opportunities and more holdings with unrealized gains. That’s bad for loss harvesting, but good for gains deferral. For mature portfolios, it’s why gains deferral becomes the dominant tax management strategy.

If Gains Deferral Is So Important, Why Don’t We Hear More About It?

Well executed gains deferral means prudently holding onto overweight positions with unrealized gains while minimizing the risk and return impact by carefully counterbalancing. Unlike loss harvesting, your work isn’t done in 30 days. The bad news is that ongoing risk-sensitive gains deferral is difficult to do well manually. The good news is that, as with year-round loss harvesting, it’s almost entirely automatable.

Ongoing risk-sensitive gains deferral is difficult to do well manually.

What Does It Take To Up Your Tax Management Game?

To efficiently implement year-round tax loss harvesting and ongoing risk-sensitive gains deferral, you’ll need to embrace automation. This will enable you to serve clients better. It will also increase efficiency and improve compliance.

More importantly, it will free your advisors to spend more time with clients and prospects, to be the financial coach they aspire to be.

Gerard Michael, President of Smartleaf, a provider of automated, customized, tax-sensitive rebalancing systems.

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