Tax-loss selling: An opportunity to improve portfolios

November 6, 2013

 

Key highlights

New tax laws and a strong stock market are likely to generate a higher tax bill for many taxpayers in 2013.
Aligning tax-loss selling with portfolio objectives could be a way to generate a "double benefit."
Advisors should be cognizant of the risks involved with tax-loss selling, including the restrictions of the wash-sale rule.
 
Sarah Hammer

Due to the new tax provisions under the American Taxpayer Relief Act (ATRA), your clients may face bigger income tax bills this year. As such, getting a jump on 2013 year-end tax planning may make a big difference in a client's tax bill. One such opportunity lies with tax-loss selling, or using realized losses on investments to offset taxable gains. However, with this year's strong equity performance, the opportunities for tax-loss selling may be reduced. Nevertheless, if you and your client are already planning to diversify or rebalance a portfolio, there may be some opportunities to take advantage of year-end tax-loss selling.

"Tax-loss selling is a potentially valuable strategy with quantifiable benefits, allowing clients to offset taxable gains as well as reduce taxable ordinary income up to $3,000 per year," said Sarah Hammer, a senior investment analyst in Vanguard Investment Strategy Group. "However, tax-loss selling requires careful evaluation of a client's portfolio and planning for optimization. Thus, tax-loss selling could be a great way for advisors to reach out to clients and to demonstrate the value of their services."

Here are a few scenarios in which tax-loss selling can be aligned with other objectives to generate a "double benefit":

  • When rebalancing a portfolio.
  • When a client is already planning to sell a security.
  • When a client wishes to reduce a concentrated position.
  • When a client wishes to sell a high-cost or tax-inefficient fund.

Now is a good time for you to reach out to clients to prepare a year-end tax-management strategy.

Look before you reap

Of course, tax-loss selling is not without risks. If a client wishes to maintain the same risk exposure in his or her portfolio, a new investment must be substituted for the one being sold. Thus, you must be cognizant of the wash-sale rule, which prohibits claiming a taxable loss on a security if there is a purchase of a "substantially identical" security 30 days before or after the sale.

"Another risk involved with the purchase of a new investment is that it resets the investment's cost basis and holding period, which—depending on circumstances—could potentially result in a reduction or elimination of the benefit of tax-loss selling," explained Hammer. "Again, tax-loss selling requires awareness of possible risks, thoughtful analysis, and long-term planning. Finally, it's useful for advisors to remind their clients that tax-loss selling is one of many available strategies for managing taxes—in addition to prudent asset location, tax diversification, and tax-efficient investing."

For more on the mechanics of tax-loss selling, its strategic considerations, and its potential risks, read one of our newer research papers, Glass half full: The silver lining of capital losses.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Diversification does not ensure a profit or protect against a loss.
  • Tax- loss selling involves certain risks, including, among others, the risk that the new investment could perform worse than the original investment and that transaction costs could offset the tax benefit. There may be tax implications. Consult your firm's tax advisor before taking action.
  • This information does not constitute legal or tax advice. We recommend that you consult a tax or financial advisor about your individual situation.
 

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