Reduce your investment taxes with a tactical portfolio structure.
Individuals in the highest income tax brackets may discover unpleasant surprises this year upon learning of their investment tax liability. In 2013, domestic equities provided investors with returns they have not witnessed since the late 1990s. This successful year for U.S. stocks was accompanied by the implementation of The American Taxpayer Relief Act of 2012 that caused an increase in the top marginal tax rate to 39.6 percent, an increase in long-term capital gains and dividend tax rates to 20 percent for those same taxpayers, and a 3.8 percent surtax on net investment income (commonly referred to as the Medicare Tax). The convergence of these two events could mean higher taxes for you.
Proper tax planning is more critical in an era of higher taxes. Five years of a rising stock market results in many traditional investment vehicles holding large amounts of unrealized gains that can become realized if you are not careful. The following suggestions could save you thousands of dollars in investment taxes over the next several years.
Be attentive to your account registration
You likely have a reasonable amount of investment experience and are familiar with the advantages of security diversification in your portfolio. But a common mistake investors make is failure to implement a tax diversification strategy. Brokerage accounts, Roth IRAs, and qualified plans are subject to various forms of taxation. Use the tax advantages of these tools to ensure they work for you in the most productive manner possible.
A properly integrated approach is critical during your accumulation phase. Furthermore, it is just as important when you enter the distribution period of your investment life cycle. Master Limited Partnerships offer a potentially advantageous income stream for a brokerage account, while it is generally preferable for qualified accounts to hold high-yield bonds and corporate debt, which are taxed at ordinary income rates. Additional examples abound, so evaluate your plan with an adviser who will consider both tax diversification and security diversification as they relate to your specific situation.
Own municipal bonds in taxable accounts
Most municipal bonds are exempt from federal taxation. Certain instruments may also be exempt from state and local taxes. If you are in the highest federal tax bracket, you may be paying tax on investment income at a rate of 43.4 percent. Under these circumstances, a municipal bond yielding 3 percent will provide a superior after-tax return in comparison to a corporate bond yielding 5 percent in an individual or joint registration, a pass-through LLC, or many trust accounts. Therefore, ensure your long-term plan uses the advantages of owning certain municipal bonds in taxable accounts.
Be aware of holding periods
Long-term capital gains rates are significantly more favorable than short-term rates. Holding a security for a period of 12 months presents an opportunity to save nearly 20 percent on the taxation of your appreciated position. For example, an initial investment of $50,000 that grows to $100,000 represents a $50,000 unrealized gain. If an investor in the highest tax bracket simply delays liquidation of the position (assuming the security price does not change) the tax savings in this scenario would be $9,800.
Although awareness of the security’s holding period is a basic principal of investing, many mutual funds and managed accounts are not designed for tax sensitivity. The average client of most advisers is not in the highest federal tax bracket. Therefore, it is generally advantageous to seek advice from an experienced financial professional to execute an appropriate exit strategy that takes holding periods into account.
Counteract gains by realizing losses
If the portfolio is structured properly, one benefit to diversifying across asset classes is that securities typically will not move in tandem. This divergence of returns among asset classes creates a tax planning opportunity. Domestic equities experienced tremendous appreciation in 2013. However, emerging market stocks, commodities, and multiple fixed-income investments finished the year in the red. Astute advisers were presented with the opportunity to save clients thousands of dollars in taxes by performing strategic tax swaps prior to year-end.
When executing such tactics, understand the rules relating to wash sales. The laws are confusing, and a mistake could result in your loss being disallowed. Make certain your adviser is well-versed in utilizing tax offsets.
Think twice about gifting cash
This is not to discourage your charitable intentions. But even successful investors can occasionally find themselves in a precarious position. You may have allocated 5 percent of your portfolio to a growth stock with significant upside. Several years have passed, the security has experienced explosive growth, and it now represents 15 percent of your investable assets. Suddenly your portfolio has a concentrated position with significant gains, and the level of risk is no longer consistent with your long-term objectives. The sound practice of rebalancing your portfolio then becomes costly because liquidation of the stock could create a taxable event that may negatively impact your net return.
By planning ahead, you may be able to gift a portion of the appreciated security to a charitable organization that can accept this type of donation. The value of your gift can be replaced with the cash you originally intended to donate to the charitable organization, and in this scenario, your cash will create a new cost basis. The charity has the capacity to liquidate the stock without paying tax, and you have removed a future tax liability from your portfolio.
Understand your mutual fund’s tax-cost ratio
Without getting into the technical details, a tax-cost ratio is the percentage of an investor’s assets that are lost to taxes. Mutual funds avoid double taxation provided they pay at least 90 percent of net investment income and realized capital gains to shareholders at the end of the calendar year. But all mutual funds are not created equal, and proper research will allow you to identify funds that are tax efficient.
A well-managed mutual fund will add diversification to a portfolio while creating the opportunity to outperform asset classes with inefficient markets, though be aware of funds with excessive turnover. An understanding of when a fund pays its capital gains distributions is a critical component of successful investing.
A poorly timed fund purchase can result in acquiring another investor’s tax liability. It is not unusual for investors to experience a negative return in a calendar year, yet find themselves on the receiving end of a capital gains distribution. Understanding the tax-cost ratios of the funds that make up portions of your investment plan enables you to take advantage of the many benefits of owning mutual funds.
Although the propositions above are by no means the only tax strategies available, you may choose to discuss various options with your adviser to determine what’s appropriate for your unique portfolio and overall financial situation. Successful investing requires discipline that extends beyond proper security selection. Gross returns are important and should not be ignored, but the percentage return you see on your statements does not tell the full story.
In today’s tax environment, successful investors must choose an adviser who will help them look beyond portfolio earnings and focus on strategic after-tax asset growth.
Andrew Taylor, CFP, is an SEC-registered investment adviser at OJM Group. He can be contacted at 877-656- 4362, ataylor@ojmgroup.com, or through fordoctorsonlyhighlights.com.
DISCLAIMER: The author is not engaged in rendering tax, legal, or accounting advice. Please consult your professional adviser about issues related to your practice.
