An oft-used catchphrase when a dramatic event comes to an end is, “Elvis has left the building.” It seems timely to also say, “The taxman has left the building.” Unfortunately, he’ll be back next year and Resource Consulting Group is preparing for his imminent return.
In our experience, most wealth advisors spend plenty of time thinking about risk and return, but not enough about taxes. That’s a shame. Especially because, unlike the stock market and interest rates, you can influence your taxes to a degree.
Investment legend John Templeton insisted, “Any investment strategy that fails to recognize the insidious effect of taxes and inflation fails to recognize the true nature of the investment environment and thus is severely handicapped.”
Tax-Managed Portfolios, a Year-Round Affair
As April 15th fades into the rear-view, it’s easy for investors to take their eyes off taxes and set their sights elsewhere. At Resource Consulting Group we know that the end of tax season doesn’t signify the end of tax liabilities. Tax management is a year-round endeavor that can help decrease your tax burden. After all, it’s not what you make, it’s what you keep. And, while tax considerations shouldn’t be the only factor to consider when investing, it should be at the forefront of any good investment strategy.
Tax-Deferred Accounts vs. Taxable Accounts
Asset location is an important consideration when looking to reduce the impact of taxes. Tax deferred accounts such as IRAs and 401(k)s are exceptional tools that can be beneficial when housing asset classes which generally have high realized gains or high ordinary income. The higher the gain or income, the greater the tax liability, which makes tax-deferred accounts optimal in these cases.
When equities are held in a taxable account for longer than one year, gains are taxable at a 15 or 20 percent long-term capital gains rate. A tax-deferred account might seem like a better option to avoid this taxation entirely. However, consider this: when funds are withdrawn from a tax-deferred account in retirement, the entire withdrawal is taxed at the ordinary income rate, which could be up to 39.6 percent. This makes proper financial planning key when deciding which asset classes should reside in a taxable or tax-deferred account. Without proper considerations it could cost a great deal more in the long run.
It’s also important to minimize turnover in taxable accounts. Realizing gains on investments held less than one year means subjecting yourself to short-term capital gains taxes as high as 39.6 percent, depending on your tax bracket. As Warren Buffett once said, “The capital gains tax is not a tax on capital gains; it’s a tax on transactions.”
A great deal of thought should be given to where to hold REITs (real estate investment trusts). The IRS requires REITs to pay out at least 90 percent of their incomes to unitholders. This income is treated as ordinary income from a tax perspective and those in high tax brackets may be better off placing their REIT exposure in a tax-deferred account.
A taxable event will occur when an investment is sold in a taxable account for a gain. Tax-loss harvesting is one way to offset that realized gain. You can reduce your tax burden by selling or trading securities that have depreciated in value over the course of the year. This is especially effective when trying to offset short-term capital gains (gains on investments held less than one year). Short-term gains are generally taxed at a much higher rate than their long-term counterparts. Also, the IRS does not limit the amount of capital losses an investor can net against capital gains, which makes this an effective tool in optimizing tax efficiency.
Gina buys Security A at $30,000 and Security B at $50,000, both in her taxable account. She sells Security A for $40,000, realizing a short-term gain of $10,000. If Security B is worth $42,000 and Gina also sells that, the $8,000 loss may be netted against the gain from Security A, resulting in taxes being owed on only a $2,000 short-term gain.
It’s important to note that if Gina intends to re-purchase the same security she sold at a capital loss to offset the capital gain, she must follow the IRS-imposed 30-day waiting period. If she re-purchases that stock before the 30-day period, starting from the date of sale, the tax-loss harvesting is disallowed. The IRS refers to this as the wash-sale rule. This rule applies to the entire investment portfolio, not just the account that held the sold security. Therefore Gina cannot sell a security and re-purchase another block in another account, such as her IRA, without adhering to the 30-day waiting period.
Market volatility provides an opportunity to utilize tax-loss harvesting, and there is no need to wait until the end of the year. By monitoring the gains and losses in the market throughout the year, your advisor can harvest losses during downturns to minimize your tax liability.
An investor who has more capital losses than gains can apply up to $3,000 of those losses against ordinary income. An investor who has greater than the allowable $3,000 loss is allowed to apply those additional losses forward to future years.
Make the Most of Charitable Donations
If you are charitably inclined, there are ways to make donations that will also help your tax bill. Rather than reaching for the checkbook, consider contributing appreciated stock. It may be possible to not only receive a charitable deduction from taxable income, but also avoid realization of any capital gains on that stock. Many charities are well versed in how to accept these assets. Alternatively, you can contribute the appreciated stock to a Donor Advised Fund (DAF) and receive an immediate tax benefit. You may then later recommend that the DAF make a grant to your favorite charity from your account.
It’s easy to see that effective tax-management strategies can greatly increase portfolio efficiency and reduce your tax burden. Resource Consulting Group understands this and works throughout the year to ensure your portfolios are tax-managed, in turn helping you keep more of the dollars you make. Focusing on these important issues eases the pain when the taxman does leave the building.