Many investors only worry about the tax efficiency of their portfolios in years when they’ve realized substantial gains. But as some discovered after experiencing significant losses in 2008, a down year does not necessarily ensure freedom from taxes on capital gains. Below are a few strategies that we recommend considering regardless of market conditions to keep your portfolio as tax-efficient as possible.
Consider tax-managed funds and separate accounts
Mutual funds are generally not known for their tax efficiency. In addition to tax, you may owe when you sell shares; you also owe on capital gains and dividend distributions—events you cannot control. If you wrongly time a fund purchase, you could owe taxes on a distribution from earnings that you didn’t accrue. “Tax-managed” mutual funds address these concerns. They intentionally limit turnover and distributions and use other strategies to minimize tax implications.
Customization and control are among the benefits of separate accounts, which are managed investments that use pooled money to buy individual securities. The manager directly purchases the securities in your own account so there are no pre-existing gains or losses at the time you invest. In addition, the manager can avoid short-term capital gains, strategically “harvest” losses to offset gains and identify specific lots for sale—three important tax-saving strategies. These accounts are typically available only to larger investors.
Make the most of tax-deferred accounts
Because of the different ways investment income is taxed, owning securities in the right types of accounts can help improve the overall tax-efficiency of a portfolio. Long-term capital gains and qualified dividends are taxed at a maximum of 15 percent. Investments that generate these typically belong in taxable accounts. Interest, ordinary dividends and short-term capital gains are subject to the higher income tax rates, and therefore, may be best kept in tax-deferred accounts such as IRAs and 401ks. The table below summarizes the types of assets you should hold in taxable and tax-deferred accounts in order to improve the tax-efficiency of your portfolio.
With all rules, there are exceptions:
- If you rely on income from your bond investments, consider holding them in taxable accounts. The income will be taxed the same, but you won’t have to worry about penalties if you’re under age 59½. For taxpayers in higher tax brackets, municipal bonds may be appropriate.
- Stocks held in taxable accounts receive a step-up in cost basis when heirs inherit them—but not stocks in tax-advantaged accounts.
- Making charitable donations of appreciated stock from a taxable account avoids capital gains, but making those gifts from an IRA generally creates a tax liability.
Understand the ramifications of selling
Holding long term. One of the simplest tax-reduction strategies is to hold investments for more than one year to take advantage of the lower long-term capital gains tax rate when you sell. But be sure to consider the investment risk of delaying a sale.
Identifying lots. When you buy the same security at different times and different prices, each purchase is referred to as a “lot.” Identifying specific lots for sale gives you greater control over how much gain or loss you realize.
Using losses to offset gains and income. Capital losses can be used to offset capital gains dollar-for-dollar. In addition, losses can be used to offset up to $3,000 of ordinary income each year. Excess losses can be carried forward to future years. You can also offset gains from one type of investment, like stocks, with losses from another, like real estate. One caveat: You can’t use realized losses in tax-deferred accounts to offset gains in taxable accounts.
Avoiding wash sales. A wash sale happens when you sell a security at a loss and then buy back the same (or substantially identical) security within 30 days before or after the sale (making the total window 61 days—including the day you actually sell—for a loss). You can’t use losses from wash sales to offset gains or income in the current tax year; the loss is “deferred” until you sell the replacement property. Also, if you sell a security at a loss in your personal account and buy it within the 30 days in your IRA, the loss is permanently disallowed. A wash sale can also be triggered by reinvesting dividends in a position within the same 61-day window.
Because of market fluctuations, your portfolio’s performance may vary. However, by using tax-smart strategies, you can at least gain greater control over the taxes you pay and keep more of what you earn. iBi