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Taxes are one of the most important variables that affect the performance of a taxable investment portfolio. The costs of trading, custodial and management fees pale in comparison to maximum federal tax rates of 15% on long-term capital gains and 35% on ordinary income (the rate at which short-term capital gains are taxed). State income taxes may further add to the tax burden. The 2003 Tax Act has several important implications for investments. Taxes matter - a lot. But at least taxes are the one aspect of asset management known with certainty in advance, and therefore we can effectively manage portfolios to minimize the tax impact. We consider tax consequences in every step of the design and implementation of a portfolio. Tactics we use to maximize the after-tax returns for each client include:
Investment Implications of the 2003 Tax Act There are three major investment implications of the 2003 Tax Act:
Lower Federal Tax Rates
Higher Penalty For Active Versus Passive Investing An 'active' investor in this case is defined as one who buys and subsequently sells securities within a one year time frame, hence realizing short-term gains or losses. The 2003 Tax Act increases the penalty for active investors relative to passive investors, as the rate spread has widened between ordinary income tax rates (the rates at which short-term capital gains are taxed) and long-term capital gains. A Growing Importance For Asset Location With the lower capital gains rate and a wider gap between income tax and capital gains tax, there is a growing importance regarding asset location decisions. Whenever possible, we place tax-efficient equities in taxable accounts and tax-inefficient fixed income (if applicable) in tax-deferred accounts. Investors experience the following disadvantages by holding equities in tax-deferred accounts versus taxable accounts:
Tactics To Maximize After-Tax Portfolio Returns 'Loss Harvesting' refers to realizing losses by selling shares that have fallen below the original cost to generate tax credits. Tax credits can be used to offset capital gains either within or outside the portfolio. Because virtually all diversified portfolios have stocks that suffer losses, selling stocks that have fallen in value is perhaps the easiest way to reduce taxes. Although the idea underlying this strategy is simple, its implementation requires diligence and discipline. Losses should be harvested only to the extent that the tax credits they generate substantially outweigh the trading costs from loss realization. Another constraint on loss harvesting is the 'wash sale' rule, which prohibits the purchase of any securities that were sold at a loss during the previous 31 days. The wash sale rule introduces a source of risk to loss harvesting. One way to minimize this risk is to simultaneously purchase stocks that share similar risk and return characteristics as the stocks that were sold at a loss. In this way, the composition and integrity of the overall portfolio is maintained. Example If Stock 1 is sold for a long-term gain of $10,000, the taxes owing are $1,500. If the remaining stocks are sold for a long-term loss of $10,000, this mitigates the long-term gain and the taxes owing are zero.
HIFO ('Highest In, First Out') Accounting Procedures In HIFO ('highest in, first out') accounting procedures, whenever one must sell a security, one sells the shares with the highest cost basis first. The rationale is straightforward. The higher the cost basis, the lower the capital gains tax. This strategy minimizes capital gains taxes without any change in portfolio weights. Example If a decision is reached to sell 2,000 shares of Stock 1, sell the shares with the cost basis of $14 per share. This strategy minimizes capital gains taxes without any change in portfolio weights.
Portfolio turnover is simply an annualized measure of the trading activity that takes place in your portfolio. It is the percentage of your portfolio that is bought and sold to exchange for other securities. For example, if there are 20 stocks in your portfolio and 10 of those stocks are sold one year so that the portfolio will be able to buy 10 more stocks, then the turnover rate is 50% (10 / 20 = 0.50). High turnover of your investments can cost you significant tax dollars, resulting in a much smaller portfolio value over time. Portfolio turnover of 20%-30% is considered low. Separate account management portfolio turnover usually falls within the range of 20%-30%. Mutual fund portfolio turnover often falls in the range of 80% or more, which is considered very high. Place Tax-Efficient Equities in Taxable Accounts From a tax perspective, it is more advantageous to place equities in taxable accounts versus tax-deferred accounts. For equities and qualified dividends, long-term capital gains are taxed at a federal rate of 15%, which is significantly lower than the maximum ordinary income tax rate of 35% (the rate at which short-term capital gains and distributions from tax-deferred accounts are taxed). Place Tax-Inefficient Fixed Income in Tax-Deferred Accounts From a tax perspective, it is more advantageous to place fixed income in tax-deferred accounts versus taxable accounts. No matter where the fixed income is located (a taxable or tax-deferred account), the interest payments will be taxed at the maximum ordinary income tax rate of 35%. Therefore, placing the fixed income in a tax-deferred account allows you to defer taxes until money comes out of the account. If the fixed income is in a taxable account, taxes cannot be deferred. Place International Assets in Taxable Accounts Placing international dividend-yielding securities in a taxable account allows the investor to utilize a foreign tax credit whenever applicable. The foreign tax credit cannot be utilized if the security is placed in a tax-deferred account. The Foreign Tax Credit The information below is not intended as tax advice but to provide a general understanding of the law. Any readers with a tax problem, including those whose questions are addressed here, should consult a tax professional for advice on their particular circumstances. Regarding foreign investments such as stock, mutual funds, or partnership interests, foreign taxes may have been paid on your behalf as a shareholder. Stepped-Up Cost Basis Lowers The Tax On The Stock You Inherit The information below is not intended as tax advice but to provide a general understanding of the law. Any readers with a tax problem, including those whose questions are addressed here, should consult a tax professional for advice on their particular circumstances. Getting a stepped-up cost basis on inherited stock allows you to save taxes when the stock is sold. For instance, if your father bought a stock at $10 a share, and it is now worth $100 a share, when he sells the stock, he will owe a capital gains tax on the $90 the stock has appreciated. If your father gives you the stock before his death, the gift will be valued at $100 a share, but you will take his cost basis of $10 a share. That means you will owe a capital gains tax on $90 when you sell the stock. If your father takes steps to give you the stock after his death, the stock will be valued in his estate at $100 a share, and you will have a new cost basis of $100. Your father's $10 cost basis gets "stepped up" to $100 as a result of his death. This is true even if your father's estate is not required to file a federal estate tax return. When you sell the stock, you will owe capital gains only if the value of the stock is higher than $100. |
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