Ninety-nine percent of the time, your financial consultants operate as a well-oiled machine. Your investment adviser dedicates his full-time attention to managing your portfolio, making the buy and sell decisions. Your financial planner ensures you have cash available when your spending needs are at all-time highs. Your tax consultant works with you throughout the year to help you pay the least amount in taxes as possible.
However, there is one practice where it becomes an all-out cage match as each of your advisers comes with a different agenda: tax loss harvesting. You might think tax loss harvesting is an “end of year” exercise, but it can be done throughout the year to help control your tax liability by taking advantage of market ups and downs.
So why the cage match? Well, maybe “cage match” is a bit of a hyperbole, but the reality is that your investment adviser’s job is to make sure the portfolio goes up, as he aims to keep you 100% invested. Now, there are times when your investment may have done so well that it has become overweight (10% or more of a portfolio) and subjects your portfolio to unnecessary risk. Trimming overweight stocks is a good way to diversify your portfolio, without having to add new money, and often that can mean recognizing capital gains or losses.
Your financial planner, on the other hand, understands your crazy hectic life and your future financial goals. She knows all about Junior’s advance-placement science summer camp and that your daughter is enrolled in the Duke TIP educational program. She knows when you’re going to need a little bit of liquidity so that you can pay for everything. So why not cash in some of those investment positions that aren’t performing as expected and use the cash for your expenses. And then, there is your after-tax return that your planner is keeping an eye on.
Your tax consultant on the other hand wants to save you money by lowering your tax bill today. Sell what you can for a loss to offset your taxes. By realizing a capital loss, you are able to offset taxes on other investments and capital gains income. Up to $3,000 of excess losses can be used to offset ordinary income, with excess losses carried forward indefinitely. Furthermore, when you sell an asset at a gain to offset your losses, you can immediately buy it back. Doing this increases the tax cost basis of the stock, which in turn, should lower any realized gain when the stock is eventually sold.
Once your financial team reaches a compromise on harvesting losses, then they argue about what to do with the proceeds. If the market goes down and you have your money in cash, you “win” because you didn’t lose any more money than you had to. But, if you have it in cash and the market goes up, you get left behind—you’re now buying on the high end when you want to get back in the market. Your third choice might be to put proceeds in a placeholder investment for 31 days so that you still capture market gains as you wait out the wash sale period; however, you could end up with a short-term capital gain—almost defeating the purpose of harvesting the tax loss.
The solution to the grudge match between your investment adviser, financial planner and CPA, of course, is foretelling the future—which not one of them can actually do. You cannot predict market returns, surprise life events, or future tax rates. While there may be a scientific method to determining your portfolio holdings and estimating your future money needs, there is an equally artistic method to balancing your level of risk to the expected rate of return on your investments after all taxes are paid. This is why it is so important to have experts that can and do work together.