Many ophthalmologists, as well as non-physician investors, wrongly assume that they should only examine ways to reduce taxes on their investments at the end of the year, when they know “how they’ve done.” Similarly, many operate under the assumption that the opportunity to reduce taxes only exists when asset values are up, so they can incur gains from any assets they sell. Because 2022 has seen market fluctuations in which most asset classes are down, we thought it was a perfect time to dispel some of these assumptions.

THE BASICS

Tax-loss harvesting occurs when an investor sells an investment at a loss to offset current or potential future gains on other investment positions. The result is that you only pay tax on the net amount of those gains/losses from positions sold, thereby lowering (or even eliminating) your taxable gain for the year. Often, the proceeds of the assets sold, for a loss or a gain, are then reinvested in a similar fund or asset class to keep the portfolio in its proper overall allocations.

The benefit here is reducing taxes—and the higher a retina surgeon’s personal income tax bracket, the greater the opportunity for tax-loss harvesting. A quick recap of current ordinary income tax rates and the corresponding capital gains rates helps to reinforce this concept: Those earning less than $40,000 as single filers, or $80,000 as joint filers, pay a 0% long-term capital gains tax. Individuals in the top tax bracket, however, pay a 20% long-term capital gains tax, and some investors are subject to an additional 3.8% net investment income tax.

THE RULES

From the Internal Revenue Service’s (IRS) standpoint, these trades are allowable if you avoid the wash-sale rule. According to the Securities and Exchange Commission, a wash sale occurs when you sell or trade securities at a loss and, within 30 days before or after the sale, you:

  • Buy substantially identical securities,
  • Acquire substantially identical securities in a fully taxable trade, or
  • Acquire a contract or option to buy substantially identical securities.

To properly execute tax-loss harvesting and reinvestment, and not run afoul of the IRS rules, it is crucial that you work with a professional advisor experienced in these matters.

TAKE 2020 AS AN EXAMPLE

Before the pandemic hit in March 2020, many investors, or even professional advisors, may have thought that loss and gain harvesting should be executed at year-end, once you understand which elements of your portfolio are up or down, and the overall tax picture for the calendar year is clearer. However, this approach is short-sighted, and we can use the calendar year 2020 to highlight why.

In 2020, if an investor waited until the fourth quarter to harvest gains and losses, they would have missed a tremendous opportunity to enjoy large tax losses because most broad-based equity investments increased significantly by year end. The opportunity to enjoy this “win-win” had come and gone by mid-2020. At one point in late March of that year, the S&P 500 was down more than 34% year-to-date; by year end, the S&P 500 rested well above a positive 10% return. If you waited until the end of 2020 to realize losses, you missed out on the potential to deploy this tax-loss harvesting strategy.

An added benefit of a portfolio that is properly diversified across various asset classes is that the securities don’t always move in tandem. This divergence of returns among asset classes not only reduces portfolio volatility, but also creates a tax-planning opportunity.

REAL-WORLD CASE STUDY

The following case study provides a real-world illustration of tax-loss harvesting in action.

In mid-to-late March 2020, Advisor Firm Alpha made trades in almost all its clients’ taxable accounts, realizing substantial losses. Alpha had an emphasis on the firm’s international equity and emerging market equity actively managed mutual funds, and targeted replacement funds in those asset classes to avoid any wash-sale issues.

Focusing on one physician’s portfolio, the Alpha team:

  • Sold all holdings in an emerging markets equity fund, valued at $619,000, but initially purchased for this client in late 2014. This transaction realized a total loss of $94,000.
  • On the next trading day, the Alpha team purchased $619,000 of a different actively managed emerging market equity fund.
  • As of December 31, 2021, that position was up 64% and was valued at $1,014,000.

In this way, the physician was in the ideal position—up significantly in that segment of their portfolio yet sitting on an almost six-figure loss for tax purposes. Further, if the investor didn’t use all the losses in 2020, the net amount would be carried forward for future tax years.

One of the key success factors for this strategy (as seen in the case study) is for the investment manager to have researched replacement funds in the target sector before the opportunity to make the trade arises. Disciplined and dispassionate investment research cannot happen the day of a trade; it needs to be done over time in advance of trading days. Ideally, an investor or their advisor has taken the time to continually identify a list of potential attractive replacement funds and has them “at the ready” so that when the targeted fund is sold to harvest the loss, they are confident of where the sale proceeds can be invested. This was the case for the Alpha team in 2020.

INVEST CAREFULLY

Tax-loss harvesting should be part of every astute investor’s game plan. Of course, you must understand the rules to implement these tactics properly, and a professional advisor can add significant value in this area. As 2020 so aptly demonstrated, tax-loss harvesting is ideally a year-round process and applicable in down markets, allowing the investor to take advantage of opportunities as they arise.

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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice, or as a recommendation of any particular security or strategy. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.