Another firm enters the fray to talk about tax loss harvesting and its value for investors.

A week ago, this publication took a look at the world of tax loss harvesting and the field of what is called “asset location”. Both these areas focus on how to minimize, or eliminate entirely, the burden of tax from certain investment processes. As the new tax year in the US looms over the horizon, such matters will be uppermost in some investors’ minds. The term “tax harvesting” is still somewhat obscure in parts of the wealth management industry. With this is in mind, Family Wealth Report spoke to another practitioner in the space, Ron Madey, CFA, chief investment officer, Wealthcare, a US firm which FWR also interviewed on other matters last year. (See here.)

He argues that there is robust academic and financial industry data pointing to the benefits of tax loss harvesting. We recently interview Madey about this subject.

Does your firm have a specific approach to tax harvesting? How much awareness is there around this? 
Yes. All our advisors are fully aware of the service and they communicate with their clients accordingly. We approach tax-loss harvesting in two ways:  1) a year-end client directed service and 2) we harvest losses against gains when rebalancing portfolios throughout the year. 

What sort of education does the firm do with clients to make them realize the benefits of tax harvesting as well as potential problems? 
It is not hard to get clients to embrace tax-loss harvesting. Everyone likes avoiding taxes. While meaningful, the benefits of tax-loss harvesting can be overestimated by clients and practitioners alike, particularly if they ignore the deferred tax liability. Some things we encourage advisors to discuss with clients to think about:  

1, Tax loss harvesting is only one leg of the tax/cost management stool. Strategies such as smart withdrawal sourcing, household-based asset location management and cost/tax-focused fund selection for mutual fund investors can provide more value. Vanguard estimates the value of these additional three strategies to be worth between 40 and 225 basis points per year. 

2, When you sell a holding at a loss to offset a gain, you are not really avoiding taxes, you are deferring them. Tax-loss harvesting lowers your overall basis. Eventually you pay the tax, unless the asset is donated or transfers at death with a stepped up basis. There is a lot of research out there that does not capture the cost of eventually paying taxes when extolling the virtues of tax-loss harvesting. It’s worth about 50 bps/year, according to Arnott [reference to a paper on the subject by First Quadrant LLP, 2001]. It depends on tax rates; the higher the rate, the more it’s worth, the lower the rate, the less valuable it is. 

3, A stock portfolio that does not receive ongoing contributions will eventually become gain-locked as stocks generally rise. So, in accumulation mode, there’s more opportunity for harvesting as you continue to make contributions to your portfolios. In distribution mode, the benefit of tax loss harvesting is diminished. 

4, Loss harvesting would be a much better deal if the Internal Revenue Service did not limit the amount you losses you can use to offset ordinary income (taxed at higher rates). However, there’s a maximum offset of $3,000/year. 
  
What kind of data is there that shows that tax harvesting can add significant value to portfolios over time?
The Arnott paper [2001 study by First Quadrant LLP] provides a simulation of tax loss harvesting that suggests it’s worth about 50 bps. There is also evidence on the matter from organizations such as Morningstar (August, 2013).