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Finding silver tax linings in shrinking portfolios

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A few weeks back, I conveyed some news to a client that made me look like a “genius” (their word, not mine).

Here’s what I told them: “A month ago, I sold part of your concentrated stock position, which generated $113,000 in long-term gains. Today, as the market has trended downward, I liquidated the entire account and generated $200,000 in losses. While your account value is a lot lower, we’ll position it for the long term shortly. In the meantime, I’ve saved you upwards of $17,000 in taxes.”

As market volatility becomes the norm, it’s created ideal situations for liquidating positions and realizing taxable losses. This approach is hardly new and is being carried out by advisors across the country, but it’s new to many clients who are seeing this strategy implemented in their portfolios. Make no mistake, it’s a drastic approach and not one to implement lightly. But in market conditions like the present, a positive impact can be made on future tax situations by liquidating positions, and you can make yourself stand out from the crowd by taking aggressive action in client portfolios.

But all this must be carefully explained to clients. Here are some things to keep in mind while doing so.

It’s not market timing

In the past month, I have utilized this approach for five clients where we had designed and executed taxable portfolios and then saw their value drop significantly in the wake of the coronavirus market volatility.

My approach in these cases is not to cherry pick which positions to drop, but to liquidate all positions that show a loss — all equities in these cases — and store the losses for a later date.

Because I did this in the middle of a down market and liquidated almost all of their positions, it has been a challenge to explain to clients why this is not market timing.

I explain that the current investment climate is giving us an opportunity to enhance their tax situation for the future. By taking this action, their portfolio will look different for a short period of time, but will get back on track either when we purchase similar investments or wait out the 30 day requirement set by the IRS. However, if the market were to continue to go down, we would preserve some of the value of their portfolio by not reinvesting the proceeds. My goal would be to reinvest the proceeds immediately, but this might not be ideal in each client situation.

Essentially, the difference between market timing and realizing taxable losses lies in the intent: My approach is all about saving on income taxes as opposed to market timing where the goal is to try to maximise returns by avoiding down days in the market.

Some clients understand the approach straightaway. For others, it takes a couple of follow-up phone calls.

“Recent further Fed action from COVID-19 seems to put another layer on a near-40-year bond bull market,” an expert says.
March 26

Strategic portfolio “switches” based on client situation

Out of the five clients who went through this extreme approach, only one was retired. One ran a business, and three were still currently working. For each, I made sure to liquidate all equities in their taxable accounts.

But after that, some strategies diverged. For the retired client, this action drastically changed their portfolio design and positions.

While the client was open to change in general, this was a big one coming off the back of implementing a new portfolio design for them. After discussion, we decided to take a break in making changes and sit in cash for the next 30 days (per IRS rules) until we reinvested their money.

The business-owner decided to stay in cash as well given that income was slowing down and she might need the cash for payroll.

The other three investors, while appreciating the approach, wanted to stay invested for the long term without a cooling-off period. Rather than go with a one-for-one exchange of securities to keep the portfolio the same, I went for a simpler solution and decided to put the account proceeds into a target date fund. I explained that this would be a holding fund that would keep them in a similar allocation, but would allow us to unwind it easily when our 30 days was up and we went back to the original investment approach.

Balancing income taxes and long-term portfolio design

Being able to liquidate positions to realize taxable losses comes down to portfolio design, specifically incorporating asset location. Putting almost all the fixed-income positions into tax-deferred accounts, and equities into taxable accounts, allows for this situation to happen organically.

Equity positions carry the risk of going down more regularly and quickly than fixed-income positions. By skimming growth off the top of equity positions during good times to create income for retirement, it allows for options when the portfolio goes into negative territory. At that point it ceases to become an income-generation approach and becomes a tax-savings approach both for the short and long term. For many clients, this two-pronged approach is not something they’d have tried by themselves.

However, having multiple approaches for one account can confuse investors and require more education than would a standard portfolio design in which each account is the same. I’ve taken time to explain to clients the role the strategy plays in their larger retirement plan, and how, while using asset location can create a better outcome in the long term, that we may deviate slightly when the market presents an unforeseen opportunity.

Once-in-a-market cycle opportunity

It’s rare, to say the least, when portfolios drop 10% to 25% in a short span of time. But in such situations, our role as advisors becomes even more important. Once we’ve got through coaching clients that their long-term situation is still OK, we need to take a close look at their shrinking accounts to determine if a silver-tax-lining can be found.

Our clients are expecting great things from us when times get rough — it’s at this moment that we really earn our paycheck. For those who know their client’s tax situation, diligently research portfolio approaches in all markets, and are not afraid to act, this could be the time when you separate yourself from the crowd. And that’s how clients can be won for life.

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