Common Sense Ways to Save Your Clients Taxes on Their Investments (November 2007)

Dominick Paoloni

If you’re like most advisors, your clients hate paying taxes. As their accountant they rely on your advice to pay as little as possible in taxes each year and to recommend tactics to help them pay less in the future. As you are well aware, a quick phone call or letter from you with periodic recommendations can save them thousands of dollars—gaining you a client for life. You are in a prime position to intercede on their behalf and to guide them toward solvent investment tax planning.

When it comes to investing, I believe too many investors have been sold the mantra that if you don’t sell and realize a capital loss then you haven’t lost any money. Essentially this is Wall Street’s way of conning the American people into believing that they should “buy and hold” investments..

The paradigm shift that your clients need to undertake is that “realizing losses is a good thing.” Because the government allows us to write off 100% of our realized losses against realized gains, capturing realized losses gives us a 100% write off, dollar for dollar, against realized gains! Talk about a tax shelter.

So how do you help your clients benefit from this tax harvesting in their investment accounts while not selling an undervalued investment? It starts with understanding and valuing diversification. Any well-designed investment portfolio should be constructed on the basis of combining investments that have a low correlation to each other, thus creating true diversification. Simply put, advisors should invest in assets that move in different directions through the same economic cycles. This management style lends itself to having a percentage of losers and winners in a portfolio at any given time. Not only is this portfolio environment favorable in terms of the tax write offs it grants your clients each year, but it also significantly enhances their downside protection in the markets. Dr. Markowitz won the Noble Prize by proposing these methods and proved that if you combine non-correlated assets in a portfolio, your reduction in risk is greater than the reduction in return—thus giving you a proverbial “Free Lunch.”

Helping your clients tax harvest in their investment portfolios is like magic. Instant write offs are generated every time you sell or realize a capital loss, like picking gold nuggets out of the riverbed. What’s more, you can give your clients this write off now or in the future, depending on their particular situation.

At the end of the year, savvy investment advisors review their clients’ portfolios for these losses and determine which funds to sell to capture a tax write off. To keep the portfolio in balance and participating in potential market gains, they then substitute a corollary fund for the losing fund—remembering again that losses aren’t necessarily bad for clients and that each market sector will inevitably experience periods of market gains and losses over time. Swapping out a fund with a negative performance for the year with a complimentary fund helps to ensure the client’s diversification remains healthy. We conduct these practices every year on behalf of our clients in their investment portfolios while keeping an eye on their core allocation.

We find that clients whose accountants help them harvest and write off capital losses experience above-average tax savings, stronger diversification in their accounts, and greater satisfaction with their tax advisors.