Tom Burroughes, Group Editor, March 20, 2017

Tax harvesting and asset location are terms associated with the mitigation, even prevention, of certain tax costs for investors. This article talks to practitioners.

There is more to a bountiful harvest than a ripening field of wheat or grape collecting in a vineyard.

The term “harvest” also has taken on significance in the wealth management industry when it comes to investors seeking to make the most of the ability to set losses in a portfolio against potential tax gains, using state-of-the-art technology to manage variations rapidly. With the US tax-filing season reaching its annual, white-knuckle crescendo (deadline is April 18), a need to understand how to mitigate the impact of taxes on investments is at the forefront of investors’ minds. And this is particularly acute given the arrival of a new administration in the White House with its promises about reducing taxes.

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.

A practitioner in this space is Trust Company of America, based in Colorado. TCA recently launched a tax harvesting feature on its account management platform to help financial advisors manage the tax impact of capital gains on clients’ portfolios with no additional cost or paperwork.

Besides the harvesting of losses to achieve lower tax, another route of tax-efficient investing is to hold certain types of investment in low-cost investment-only variable annuities that are tax-deferred. For such annuities, which are provided by firms such as Jefferson National (based in Kentucky), an investor will put assets into the annuity that are seen as relatively inefficient from a tax viewpoint, such as Real Estate Investment Trusts and forms of fixed-income investments.

This sort of approach is known sometimes as “asset location,” of putting certain asset types in a  tax-deferred vehicle to mitigate clients’ tax while retaining the same overall “asset allocation”, Lindsay Faussone, vice president of business development at TCA, told Family Wealth Report in a call.

“With investments, you have to look at the tax erosion impact as well as at fees,” Faussone said.

Tax harvesting and asset location approaches stem from the same challenge of reducing the drag on investment performance from tax, she continued. “I look at asset location as a way of preventing tax, and tax harvesting as a way of minimizing tax impact,” Faussone continued.

Her firm, a platform and custodian for fee-based advisors, does not provide proprietary products– there is no conflict of interest as far as clients are concerned in such cases, she said. Such activity is a classic example of advisors doing their best for clients, she said.

Harvest gold

The recent election, whatever else it did, has put tax on the agenda, and given a fresh edge to the need for nimble tax harvesting, argues JC Abusaid, president and chief operating officer of Halbert Hargrove, which is headquartered in Southern California. (That firm has offices in San Diego, Washington State, Denver, Texas and Arizona. The firm is fee-only, charging one percent of AuM starting at $1 million, and lower charges on larger amounts.)

“We’ve been very careful right from the outset of the [presidential] campaign to state that we are highly active on the tax impact on clients. So today we are not doing anything differently,” he said. “We’re hypervigilant,” he continued.

“I think tax harvesting is under-appreciated,” he said.

Abusaid said his firm has always been proactive about the impact of tax on portfolios, with the harvesting of losses a daily, relentless process rather than something undertaken once every six months or at the end of a financial year.

And in sometimes volatile markets where there are dislocations and rapid changes, the potential to use the tax harvesting technique is wide, Abusaid continued.

Some history

As the saying goes, there are two inevitable things in life – death and taxes. And as long as taxes have been in force, investors have sought solutions to keeping down the impact. In the US, lawmakers enacted rules as a part of the Revenue Act of 1921, which declared that if the investor sold an investment for a tax loss but purchased a substantially identical security that the loss would be disallowed for tax purposes. In effect, Congress enshrined into law the strategy of tax loss harvesting to generate current tax savings.

To take an example, as shown on the blog of Michael Kitces in 2014 (www.kitces.com), if an investment was originally bought for $20,000 but is now down to $14,000, then harvesting the loss generates a $6,000 capital loss, which in turn (assuming there are capital gains to offset it against) will produce a $900 tax savings at a 15 per cent long-term capital gains tax rate. Relative to an investment value of $14,000, this means harvesting the capital loss generated a “tax alpha” of $900 / $14,000 = 6.4 per cent.

The investment industry is familiar with terms such as Alpha (the added value supposedly gathered by superior stock-picking skill of a manager) and in a paper in 2013, Morningstar, the fund research house, talked of wealth planning/structuring techniques – including around tax – that provided “Gamma”. The analysts reckoned that, based on a simulation carried out, a retiree can expect to generate 22.6 per cent more in income using a Gamma-efficient retirement income strategy when compared to a base scenario, which assumes a 4 per cent initial portfolio withdrawal where the withdrawal amount is subsequently increased by inflation and a 20 per cent equity allocation portfolio. In plain language, managing money is more than trying to be the next Warren Buffett.

Benefits

A benefit of the tax harvesting approach is that an investor doesn’t have to worry about trying to predict a market’s direction, Abusaid said.

The term “tax harvesting” may not be widely known today. “I think even a lot of accountants are not aware of the term – that’s been my experience, he continued.

There are certain restrictions, such as if an investor sells an asset to harvest the loss, that person cannot repurchase it for a minimum period (30 days).

“If you’re building a portfolio for a family you are going to have tax-efficient and inefficient assets, so you need to be smart about where you put them,” he said. Despite the importance of tax, managers try and avoid the “tax tail wagging the investment dog”, and consider the merits of investments in the round, he said.

It’s also important to note a client might have a significant loss carry forward from a previous investment, which then can offset significant amounts of future investment gains. Being aware of a client’s income and loss carry forwards help guide asset location decisions such as investing in municipal vs. corporate bonds, he added.

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