TaxLossHarvesting

If you’re planning to switch from your losing investments to different options like exchange traded funds, tax loss harvesting provides a tax-advantaged way to do that.

Despite the real tax benefits associated with loss harvesting, many investors don’t do it. Behavioral finance offers one possible reason why — research has shown that losses hurt more than gains, meaning investors may want to ignore their losses to avoid the pain associated with them.

Why is it important for investors to overcome this psychological hurdle? And how can advisors help them to do just that? I recently sat down for a question and answer session with Mark Balasa, a principal at fee-only wealth management firm Balasa Dinverno Foltz LLC in Itasca, Ill.. Mr. Balasa, frequently cited as one of the top financial advisors in the country, really knows the nitty gritty of the subject. He helped design iRebal, software that helps optimize portfolio rebalancing and loss harvesting.

Here are excerpts from our conversation:

Q: How do you go about tax loss harvesting for your clients each year?

A: If you look historically at rebalancing and tax loss harvesting, many people tied it to a calendar time frame and do it once a year in the fall, or once a quarter. Our view is a little bit different. We look all year long, every 10 days, for harvesting or rebalancing opportunities. Why? Take last year. In the first part of the year, the market was up. In the middle through July, the market was down, and by the end of the year, it was up. If you took the historical approach of waiting until December or November to harvest losses, because that’s when it’s time to think about taxes, everything would have rebounded and you would have lost your opportunity. By looking all year long as opposed to only on certain calendar dates, we don’t miss those opportunities. Using software such as iRebal also enables us to be very specific about whether it’s more beneficial to use LIFO, FIFO or average cost to calculate cost basis. In the old days before software, figuring out which cost approach to use in Excel got very tough, so most people just used average cost as their basis.

Q: Do you ever get feedback from clients that they don’t want to talk about losses?

A: If anyone ever doubted prospect theory, all you have to do is tag along on a couple meetings to see it’s true. Some people get loss harvesting intellectually, but emotionally they don’t, and some don’t get it intellectually or emotionally. The behavioral finance component rears its head in a couple of different ways. If you go back to 2008 and 2009, when we had opportunity after opportunity to harvest, it got really stressful for clients, even the ones who understood it conceptually. After a while, they would say “Don’t do anymore of that. I don’t want anymore losses. I don’t want to talk about it or hear about it.” In a more normal environment (hopefully like this year), most people are ok with it. But you still have people that, depending on the level of understanding, will say “Why would we want to talk about losses. We’re looking for gains.”

What caught me by surprise a long time ago is people’s accountants. When clients go to file their 1040s at the end of the year and their accountants see a bunch of trades from us and all the losses, the accountants go “What are they doing over there? They’re just losing money.” They don’t see the context of what we’re trying to do. I often need to reach out and educate the accountants as well.

Q: How do you educate clients – and accountants – about the value in tax loss harvesting?

A: It’s the numbers. It’s not too hard to show, in terms of math, if we take a loss and can use it to offset a gain, it’s a good thing. Typically, I’ll go up to the whiteboard and give a very specific example – using a client’s portfolio – to illustrate how tax loss harvesting works and the benefits associated with it. Usually, that kind of education is the trick. Here’s an example: Let’s say in January 2011, you invest $20,000 in an ETF stock fund. Then in March, the investment’s value drops to $14,000, you sell the holding at a $6,000 loss and you invest $14,000 in another ETF (we recommend clients generally stay invested). The $6,000 loss can be used to reduce your 2011 capital gains — and it reduces your income tax by $900 ($6,000 x .15). If you then invest that $900 and it grows by 7% for five years it is worth $1,262.

Q: What else should we know about tax loss harvesting?

There is opportunity on the bond side for this too. It’s more complicated and there are more things to think about, but many times people just think about tax loss harvesting and the stock side of the portfolio. Also, if people have come into the market in the last year or two, the last two years have provided ample opportunity for tax-loss harvesting.

 

The information and examples provided are not intended to be a complete analysis of every material fact respecting tax strategy and are presented for educational and illustrative purposes only. Tax consequences will vary by individual taxpayer and individuals must carefully evaluate their tax position before engaging in any tax strategy.

BlackRock is not affiliated with Balasa Dinverno Foltz LLC.