Imagine your client calling to tell you they've found their dream vacation home but need to liquidate $50,000 to help with the down payment. They anticipate many additional house expenses and want to avoid taking a huge tax hit. Sound familiar? Portfolio managers face this type of scenario daily. Clients start with long-term, goal-oriented investments, but requirements and opportunities constantly evolve. So, how do portfolio managers raise the cash without taking a huge tax hit? First, they must consider specific questions:
- How to identify what to sell and from where to sell it?
- How to stay exposed to the broader market if they don't require immediate proceeds?
- When is the right time to buy back in?
- Is this an opportunity to buy something more conservative?
- Is there a need to carry losses forward into the next year?
A lower tax bite can significantly change the total after-tax performance of a family or household. Reducing capital gains by even a few basis points can result in substantial tax savings for investors in high tax brackets. That's why the ability to track and manage tax lots and a thoughtful asset location strategy are crucial tools for investment managers to make trading decisions that will deliver the optimal tax treatment for their clients.
Tax-loss harvesting is an increasingly popular strategy for mitigating tax impacts. This practice allows a portfolio manager to offset taxable gains from a prior sale by selling a security at a loss and then using the proceeds to buy a comparable security. Incurring the loss minimizes the overall year-end tax impact on the investor’s portfolio while replacing the stock maintains the desired exposure.
Tax loss harvesting approaches:
- Direct Indexing: This practice is pioneered by several firms and is now a growing trend among investment managers. This method allows investors to systematically replicate an index within constraints like exclusions, tracking errors, ESG, and tax budgets.
- Personalization: Many firms require a less algorithmic approach or a method to complement their direct index strategy. In these scenarios, portfolio managers place tax-efficient investments, such as municipal bonds and index ETFs, in taxable accounts and actively traded securities in tax-advantaged accounts. This approach combines strategic asset location and targeted tax loss harvesting.
Regardless of the approach, these tax considerations introduce complexity in day-to-day business operations. It could be data integrity at the tax lot level, complicated multi-account households, or additional relationships and communication with third-party providers. There is no right answer, but firms should clearly understand opportunities, risks, complexities, technology, and operational requirements when looking to improve upon or implement tax-efficient activities.
At SS&C Advent, we are excited about the future of investment management technology and are committed to empowering our clients in this dynamic market. To learn more about our solutions that support tax lot tracking, contact us or request a demo.