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Introduction
For many advisors, tax loss harvesting is the single most important tool they have in their arsenal for reducing taxes on behalf of their clients. There are numerous studies that indicate that, next to inflation, taxes remain the biggest drain on a portfolio as taxes can reduce returns by up to one percent per year.
Advisor Rebalancing offers options for tax loss harvesting and tax management which are outlined below. For more information on the specific actions you can take within Advisor Rebalancing for tax loss harvesting and tax management, see Using Advisor Rebalancing for Tax Loss Harvesting.
Tax Management Benefits
Tax loss harvesting can reduce an investor’s taxes. Although tax loss harvesting can’t restore losses, it presents opportunities to increase the return in a client’s account. As with any advice about taxes, please consult a tax professional for specific advice on tax management.
Tax-managed investing provides the following benefits to the investor:
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Taxes can bring down averages by 75 to 100 basis points per year. Tax-advantaged investing may add roughly 60 basis points of after-tax alpha per year.
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When investment losses are harvested, this triggers reductions in the client’s tax bill and delivers a reliable and measurable tax alpha for the client’s after-tax return.
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By realizing losses, over a 25 year period, portfolios can add about 27 percent to a typical buy-and-hold strategy in typical market conditions.
Tax-managed investing provides additional benefits to the advisor as well:
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Tax loss harvesting can increase the depth of relationships with clients. The strategy can allow you to consider all of the client's investments rather than just the assets that you are currently managing.
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Harvesting losses can offset gains generated outside of a client's portfolio. For example, harvesting losses can offset income such as gains from the sale of real estate.
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Tax loss harvesting can bring about referrals from custodians, CPAs, attorneys, etc.
Best Practices
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If the long-run return of the retained asset is at least 90 percent of the security considered for replacement, then the taxable investor is ahead of the game by retaining that stock.
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Proactively monitor mutual fund capital gain distributions and avoid buying them prior to record date.
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Use directed trades to sell out of securities that have upcoming distributions.
Available Settings and Settings Logic
The following is a summary of the settings available within Advisor Rebalancing that affect tax management. You can adjust these settings to fit your needs and specific strategies.
System Settings
On the System Settings page, you can choose one of these Tax Loss Rebalance Settings which will then apply to all accounts:
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SELL ENTIRE SECURITY: When you select this option, Advisor Rebalancing will sell out of a position that has surpassed the loss threshold you've specified at the account level.
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SELL ONLY LOSSES: When you select this option, Advisor Rebalancing will sell only the lots that have incurred losses for the security which are beyond the loss threshold you've specified, and will not sell the lots that do not meet the loss criteria or that have gains.
Example
A client's tax loss harvesting thresholds are 15% and $5,000. The client has a security with 10 lots. Seven of those lots have gains and three have losses, and the average loss and net loss surpass the account thresholds:
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With the Sell only losses option selected, when you perform a Tax Loss Harvesting rebalance, only the three lots with losses will be sold. The losses on the individual lots do not need to meet the loss threshold, only the average of all losses for the security:
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With the Sell entire security option selected, when you perform a Tax Loss Harvesting rebalance, all 10 lots of the security will be sold:
Account Settings
When changing the account-level settings for existing accounts, or opening new accounts, you can change the following settings for tax optimization:
Sell Based on Tax Optimization
Advisor Rebalancing gives you the option to sell securities in the most tax efficient way possible. When you select Yes for Sell Based on Tax Optimization on the Account Settings page, Advisor Rebalancing will rebalance to your investment targets at the lowest possible tax cost to the client.
To create tax optimization, Advisor Rebalancing ignores any ranks and sells in the following order:
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Securities with losses
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Securities with no tax consequences
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Securities with gains
Closing Method
You can adjust an account's closing method on the Account Settings page.
Closing methods allow clients to receive tax benefits at the lot level and the closing method you choose allows you specify how you'd like lots sold in that account. This setting is also used to calculate realized gains and losses when rebalancing an account.
Notes
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When using a tax loss harvesting rebalance option, the closing method used will automatically be Tax Optimization, regardless of the setting chosen.
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Closing method is communicated through the "versus purchase" portion of those trade files that support it. Not all trade files support the Tax Optimization closing method.
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Closing method must be the same at the custodian, on the Account Settings page, and in your Portfolio Accounting System (PAS).
Tax Loss Harvesting Settings
The Tax Loss Harvesting Settings section can be found on the Account Settings page.
The Sell all securities with a percentage loss greater than field lets you set a percentage of loss value compared to the total position value. The A dollar loss greater than field lets you set a specific dollar amount of loss. Securities will be recommended for sale in a tax loss harvesting rebalance if they meet these two thresholds.
Example
You have a client account where the tax loss harvesting thresholds are 15% and $5,000.
Your client holds ABC at a loss of 20% of the security's value, but because the client doesn't have many shares of ABC, the total loss held in ABC comes to $1,000. Because this doesn't meet threshold settings in that client's account, ABC will not be recommended to sell in a tax loss harvesting rebalance.
Determining Your Tax Loss Harvesting Thresholds
On an account-by-account basis, you can define the minimum size of loss you are willing to realize before tax loss harvesting. Many firms choose to only define a loss threshold in dollars and leave the percentage at zero.
Best Practices
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Loss threshold is generally arrived at based on the round trip cost, the minimum tax savings, and the client’s tax rate. You can use this calculation as a general rule of thumb to start with:
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Use the percentage loss field to avoid realizing a small loss and selling a very large sized position. For example, a client's account may have a $2,000 loss in a security, but may get a recommendation to sell a large position of 15,000 shares just to realize this relatively small loss.
Note
The realized gains and losses fields are synced with the information that appears in Advisor View. If you don’t use Advisor View, these fields can still be uploaded using the Account Information upload. These fields are for informational use only and are not taken into account when Advisor Rebalancing recommends trades.
Asset Location Preferences
Setting asset location preferences and model priorities allows you to specify where assets will be placed in a rebalancing group during the rebalance process. This is a useful tool because it can mean more tax-advantaged placement of assets and potentially higher returns because of reduced tax burden.
For more information on how tax management fits into this process, see Asset Location and Model Priorities - Introduction and Navigation.
Restoring Accounts Back to Their Models
After harvesting losses in accounts, you may find those accounts need to be rebalanced to be brought back to their model allocations. In some cases, you may have excess cash in the account. Depending on your strategies, you can use these tactics in Advisor Rebalancing to reinvest excess cash and restore accounts back to their models.
Using Excess Cash
If you have excess cash in the account, you can use the following strategies to reinvest cash back into your clients' models:
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After harvesting losses, you can use a saved search or create an account set to create a list of those accounts with excess cash.
Best Practices
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To track accounts with excess cash as a result of tax loss harvesting, go to the Upload page and create an Uploaded Search saved search. Upload a list of accounts with excess cash. Then, use that uploaded saved search to create an account set.
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Add a keyword to accounts where you have excess cash as a result of tax loss harvesting to keep track of those accounts. For example, give those accounts a keyword like "Tax Loss Harvest 11/1/2015." That way, you can easily identify those accounts and repurchase securities within the accounts in 31 days. This puts cash back into the market in the same security and avoids a wash sale.
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You can track excess cash by putting the cash into reserve. This prevents the cash from being reinvested during the rebalance process. After 31 days, you can then remove the cash from reserve and reinvest into the same security.
Immediately Reinvesting
If you want to ensure that cash is immediately reinvested into the account, you have these options:
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Remove the securities being sold for their losses from clients' models and then run a rebalance. This will get accounts back into their models.
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You can reinvest into equivalent securities. Immediately purchasing a similar security avoids a wash sale but puts cash back into the market instead of sitting in the account.
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You can use a Buy Only rebalance after sells settle to invest in alternative securities in your Security Level models or substitutes for the securities sold.