Increased stock and bond market volatility can present opportunities for investors looking to reduce ordinary income or offset current and future capital gains with capital losses. To help turn such market volatility into an advantage, IFA's portfolio management and research team looks for opportunities to tax-loss harvest (TLH).

How does this work? Basically, when individual securities or funds that are held in taxable accounts decline in value below their cost basis (i.e., how much you paid for it), these can be sold to lock-in capital losses. Those losses can be used to reduce potential tax burdens by offsetting realized capital gains and/or reducing ordinary income.

The potential benefit for our clients: Realized losses that aren't utilized in the current tax year can be carried forward for as many years as necessary until completely used up. As a result, a market downturn provides investors with an opportunity to examine their specific tax situations and determine if they've got additional capital gains that can be offset by losses harvested from their portfolio. These capital gains might come from a variety of areas — including fund distributions, portfolio rebalancing and proceeds from the sale of real estate or a business.

Given the tax-offset value of realized capital losses, investors need to consider a disciplined and consistent TLH strategy after stock or bond positions have experienced a large enough decline. In a nutshell, below is a basic overview of how our process works and IFA's research methodology supporting tax-loss harvesting. 

An Overview of IFA's TLH Methodology

Initially, our portfolio managers will sell equity index funds in clients' taxable accounts that have declined in value by 10% or more and have a minimum capital loss of $5,000. For fixed-income funds, the percentage criterion can be as low as 5% and $5,000.

The above minimum targets for percentage and dollar value declines are key components of IFA's tax-loss harvesting strategy that was developed to produce at least a 90% probability of positive net outcomes for our clients. However, it considers that risks associated with TLH, including market volatility, may prevent TLH from proving beneficial 10% of the time. 

At IFA's discretion, such criteria might change as market conditions warrant. This sale will create a realized short-term capital loss on the sold funds held for less than 12-months and a long-term capital loss on sold funds held more than a year. 

The proceeds will be invested into a different alternate fund. By IRS rules, these changes can't be made into a "substantially identical" securities. As a result, IFA's portfolio team substitutes funds that are intended to follow such tax guidelines.  

For example, we might choose to sell a client's position in the DFA US Large Cap Equity Portfolio (DUSQX) and re-invest those proceeds into another domestic large-cap fund, the US Equity ETF (DFUS). That's just one possible substitute we've identified, though. As part of our ongoing TLH review process, IFA's portfolio management and research group keeps refining its list of tax-loss harvesting alternatives in different asset classes. These TLH fund choices are made with input from Lisa Rimke, head of IFA Taxes and a certified public accountant (CPA). 

After 31 days from the purchase of the alternate fund, we'll liquidate it and use the proceeds to repurchase the original position. The aim of this process is to ensure that an investor's overall portfolio asset-allocation and risk exposure remains the same as it was prior to performing TLH.

This 31-day period avoids the IRS Wash Sale Rule, which states that a wash sale occurs when you:

• Purchase the same securities within 30 days before-or-after the sale.
• Buy or otherwise acquire "substantially identical securities" within 30 days before-or-after the sale in any account. (If you buy the substantially identical stock in your IRA, you also have a wash sale.)

A gain/loss report and a 1099 from each client's custodian will indicate the gains and losses for the tax year. Individuals can use up to $3,000 of capital losses to offset their ordinary income in any given tax year ($1,500 for a married person filing separately). If you realized $10,000 in capital losses, a taxpayer would be able to apply $3,000 of their net capital loss to reduce their current taxable income, leaving $7,000 in unused net capital loss to offset current tax-year capital gains or carry forward for future tax years. 

Tax-loss harvesting is not market timing. By purchasing an alternate open-end fund or ETF, investors remain fully invested for the 31-day period after harvesting the loss. Still, this process doesn't come without opportunity and trading costs.

When we invest deposits, rebalance or tax-loss harvest — and an IFA Index Portfolio implementation calls for an exchange-traded fund — we'll replace a mutual fund position with an ETF. 

IFA's investment committee continually reviews all of our portfolio implementations. When appropriate, we'll replace a mutual fund position with an ETF. As a result, during the implementation process, original mutual fund positions might be replaced with the current ETF implementation. 

Maximizing Potential ETF Tax Efficiencies

Since IFA utilizes both open-end mutual funds and ETFs for portfolio implementation and TLH, it's important for you to understand some of the other nuances involved in trading these two fund types.

For one, open-end mutual funds trade based on a closing net asset value (NAV) at the end of each trading day. Opportunities don't usually exist to trade a mutual fund during trading hours and the fund trades at its daily closing NAV. Conversely, an ETF trades similar to an equity stock in that it can be bought and sold at any point during market hours. As a result, an ETF can trade below (discount) to its NAV, at its NAV or above (premium) to its NAV throughout the trading day.

When the TLH process requires IFA's portfolio management team to sell an open-end mutual fund and use the proceeds to purchase an ETF, it will always execute the ETF purchase on the next trading day. This is done to eliminate a potential scenario where intra-day market volatility causes the amount of the ETF purchase to be greater than the amount of the proceeds derived from the sale of the open-end fund at the end of the trading day. This is commonly known as "double exposure."

By waiting until the next day to purchase the ETF, the risk of not having enough proceeds to cover the same-day purchase is removed. However, this process does introduce the possibility that the price paid to purchase the ETF on the next day will be higher than the previous day. Given that the price of the ETF at any given moment is a random event and impossible to predict, IFA focuses their processes on extinguishing the double exposure risk.

For instances where an ETF is being sold with the intention of using the proceeds to purchase an open-end fund, both transactions will occur on the same trade date. This is possible due to the fact that IFA's traders will know the total value of the sale of the ETF prior to entering the order to purchase the open-end fund.

There is another important trading scenario that takes place during TLH. This happens when one open-end fund is being sold to purchase another open-end fund. In this circumstance, IFA's portfolio management department will liquidate the entire position in the first fund and buy a partial position in the second fund. The remainder of the second fund will be purchased at the closing NAV on the next trading day after the final amount of the liquidation is known. Projecting a partial buy amount is possible because the purchase is based on the NAV of that fund at the close of the trading day and not on an intra-day price.

A Closer Look at Block Trading & Risk Aversion

When possible, IFA combines or "batches" all client ETF trades into block orders. Once batched, the IFA portfolio management department will communicate directly with the institutional trading desks at the relevant custodian to understand the current volume and pricing of the ETF.

The institutional traders at each custodian work closely with IFA's portfolio management department in the execution of the entire block order. Block orders are typically executed twice daily at 9:30am PT and 12pm PT. At IFA's discretion, these execution times will vary depending on many factors to include but not limited to the size of a block order and current market conditions. In the pursuit of best execution for ETF block orders, it is important to note that IFA intentionally avoids placing these orders at the market opening and closing.

In addition to the intricacies involved with the trading and execution side of TLH, there are additional risks clients should consider before deciding to undertake this process. Some examples of these risks are listed below but you should consult with your IFA wealth advisor regarding your individual situation before moving forward with TLH.

1.) Take a fund that's sold at a 10% long-term capital loss and those proceeds are temporarily re-invested in an alternate fund. If that alternate fund increases by 5% during the 31-day interval, such a gain can be expected to be used to offset a portion of that long-term 10% capital loss from the sale of the original fund. So your resulting benefit in this example would be a 5% capital loss that could be used to offset capital gains and/or reduce ordinary income. 

2.) During the minimum 31-day interval required to book losses, the alternate fund will almost certainly obtain a different return than the funds sold. This isn't surprising since these temporary alternate funds use "not substantially identical" securities. Such a risk is the only reason the IRS allows this loss to be kept by investors.

3.) There are transaction fees to be paid to the custodian (Schwab, TD Ameritrade or Fidelity). No additional fee is paid to Index Fund Advisors.  

While tax-loss harvesting involves some risks, our studies of actual outcomes of IFA clients indicate that it produces positive benefits over extended periods. We highly recommend that investors check with an IFA wealth advisor and a tax professional to make sure booking losses against any possible capital gains fits with their longer-term financial and tax planning goals. IFA Taxes, our tax-planning and preparation division, offers free initial consultations. You can reach CPA Lisa Rimke by email at [email protected] or phone at (888) 302-0765. 

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This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful.  Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. Take the IFA Risk Capacity Survey (www.ifa.com/survey) to determine which portfolio captures the right mix of stock and bond funds best suited to you.  For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.

Certified Public Accountant (CPA) is a license to provide accounting services to the public awarded by states upon passing their respective course work requirements and the Uniform Certified Public Accounting Examination.