For financial advisors managing portfolios for high-net-worth clients, few mistakes are as costly – or as avoidable – as inadvertently triggering short-term capital gains. Yet in the rush to implement investment strategies and respond to market opportunities, advisors often fall into what we call the short-term trap, where timing can destroy tax efficiency.
To help you avoid this trap, we’ll dive into the true cost of short-term gains and walk through some strategies for protecting your clients' after-tax returns below.
The hidden damage of short-term capital gains
The tax code treats short-term and long-term capital gains very differently, and for high-income investors, the difference can be substantial. Long-term capital gains – those on assets held for more than one year – are taxed at 0%, 15%, or 20%, depending on the client’s income. But short-term capital gains are taxed as ordinary income at rates that can reach 37% at the federal level, or even higher if the investor is subject to the 3.8% net investment income tax (NIIT) that was created in 2013 as part of the Affordable Care Act.
As a result, higher income investors in higher tax brackets are often paying twice the tax rate on short-term gains compared to long-term gains.
The pain doesn’t stop there, because state taxes can increase the burden. In high income tax states, investors may face combined federal and state tax rates of 50% or more on short-term capital gains, while long-term gains in the same state might only face a combined rate of around 25%. So, a poorly timed trade can cost clients 25 percentage points or more in additional taxes, which can be a devastating blow to portfolio performance.
Common triggers for the short-term trap
The short-term trap typically ensnares advisors in two key situations:
- Account transitions: When advisors win new accounts, they often inherit legacy holdings with embedded short-term gains. While the natural impulse is to quickly implement the new investment strategy, doing so can trigger substantial short-term capital gains taxes. Successful advisors recognize that transitioning to the preferred portfolio takes time and patience.
- Model changes across multiple accounts: If advisors are managing multiple accounts with the same model, and they make a strategy change that applies across a hundred client accounts with different holding periods, some trades may generate short-term gains. Scaling a business while maintaining tax efficiency requires careful consideration of each account's individual tax situation.
Strategic approaches to avoid the trap
Avoiding the short-term trap requires disciplined investment philosophy, smart timing decisions, and systematic processes. The most successful advisors employ multiple strategies that work together to minimize tax impact while maintaining portfolio objectives. Here are three key approaches.
The zero short-term gains philosophy
One effective way to protect clients’ returns is to establish a zero short-term capital gains budget. This philosophy recognizes that avoiding short-term gains is often more valuable than other tax strategies, including traditional tax loss harvesting.
This doesn't mean never realizing short-term gains, but rather ensuring that any short-term gains are offset by short-term losses elsewhere in the portfolio, resulting in zero net short-term gains.
Timing-based strategies
Smart timing can turn potential tax problems into opportunities for greater efficiency. These tactical approaches focus on when trades are executed to optimize after-tax performance without compromising investment goals.
Gains deferral: Sometimes the best trade is the one you don't make – yet. If a portfolio change triggered short-term gains in November or December, consider waiting until January. This delay serves two purposes: it pushes the gain into the next calendar year, and it provides an entire 12-month period to harvest losses that can offset the gain.
The 12-month advantage: Having a full year ahead provides maximum flexibility for tax planning. Model changes made late in the year leave little time for offsetting strategies, while changes made early in the year allow for comprehensive gain-loss matching throughout the remaining months.
Hold vs. trade analysis: Before making any trade that would trigger short-term gains, conduct a rigorous analysis: Does the investment benefit justify the tax cost? Sometimes holding a less-than-ideal position for a few more months to reach long-term holding thresholds is the superior choice.
Systematic risk optimization
Advanced tax management involves creating a systematic approach that evaluates every potential portfolio change through a tax lens. This process evaluates:
- Current holding periods for all positions
- Embedded gains and losses throughout the portfolio
- Opportunities for gain-loss matching
- The time remaining in the calendar year
- Client-specific circumstances that might require exceptions
Minimizing tax impact with Envestnet Tax Overlay
Managing clients’ capital gains can be complex and time-consuming – but it doesn’t have to be. A service like Envestnet Tax Overlay can work to reduce or eliminate short term capital gains, automatically.
By continuously monitoring the impact of trades and considering all the critical elements affecting tax efficiency, Envestnet Tax Overlay provides a scalable way to optimize after-tax returns across your entire client base. The service also makes it easier to tax-efficiently transition existing portfolios from new clients and identify tax-smart opportunities that align with investors’ objectives.
The bottom line
In tax management, timing truly is everything. The difference between short-term and long-term capital gains treatment can represent 25 percentage points or more in tax savings – a difference that can make or break a client's long-term wealth accumulation strategy.
Clear communication is essential when implementing timing strategies, otherwise clients may not understand why their portfolio transition is taking longer than expected or why certain trades aren’t being made immediately. Explaining the short term trap can help clients appreciate the strategic thinking behind these decisions and demonstrate your value as a tax-aware advisor.
By making the elimination of short-term capital gains a primary objective, employing systematic timing strategies, and clearly communicating the tradeoffs to clients, advisors can avoid one of the costliest mistakes in portfolio management. The patience required to avoid the short-term trap isn't just good tax planning – it's good business.
Learn more about Envestnet Tax Overlay at www.envestnet.com/tax-overlay
