If you’re not following a tax-efficient investing strategy, you could be seriously shortchanging your portfolio.
According to a report from Research Affiliates, taxes — not market volatility or fees — represent the biggest drain on investment returns. Higher turnover rates increase the tax impact, but taxes can still have significant implications for investors even when turnover is low.
Investing in tax-advantaged accounts is one way to beat the tax bite, but you’re constrained by annual contribution caps. A taxable account, on the other hand, isn’t bound by those same restrictions.
“The primary advantages of a taxable brokerage account are flexibility and control,” says Jean A. Wilczynski, financial advisor at Exencial Wealth Advisors in Old Lyme, Connecticut. “Unlike tax-deferred or tax-free accounts, a taxable brokerage account does not come with limits regarding amounts to be invested each year, penalties for early withdrawals or required later withdrawals.”
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These accounts can also offer greater freedom when it comes to how you invest, Wilczynski says. “With a taxable brokerage account, the sky is the limit: the investor controls which assets to invest in.”
The investor also controls when they tap those assets, says John Woods, CEO of Southport Capital in Atlanta. “Taxable accounts allow easy access to cash if you want to liquidate securities.”
Another big advantage is that you don’t pay income tax on withdrawals like you would if you were withdrawing money from a traditional individual retirement account or 401(k), says Albie MacDonald, managing director at MAI Capital Management in Ponte Vedra Beach, Florida. “You’re subject to potential capital gains, however in most instances it’s a lower rate than you would pay if it were taxed as ordinary income.”
While those benefits are appealing, you must still be conscious of potential tax consequences. If you’re supplementing a 401(k) or similar plan with a taxable account, commit these tax-efficient investing rules to memory.
Know what you own. Asset location is something you don’t want to get wrong for tax-efficient investing.
“Taxpayers typically mishandle how they should allocate assets in each type of account,” says Jeff Fosselman, senior wealth advisor with Relative Value Partners in Northbrook, Illinois. “The norm is to either treat taxable accounts and qualified accounts as fully allocated mini portfolios, or to put the more aggressive assets in retirement accounts.”
This is a mistake because it doesn’t enable you to take advantage of the respective tax benefits of each account, Fosselman says.
Mike Repak, vice president, senior estate planner at Janney Montgomery Scott in Philadelphia, says the tax efficiency of an investment in a taxable account depends on both the returns generated and the after-tax returns, based on the tax character of the income.
“Stock funds, for instance, are generally tax-efficient since their returns are normally dividends and/or long-term capital gains taxed at more favorable rates,” he says. “However, short-term or actively managed funds may be tax-inefficient as they are more likely to produce income which is taxed at a higher rate.”
Bond funds also fall into the tax-inefficient category, as their interest earnings are more heavily taxed. Reviewing your holdings across both taxable and tax-advantaged accounts is important for identifying mismatches in your allocations.
Don’t underestimate the tax drag. You can’t afford to miscalculate your potential capital gains tax liability if you’re focused on tax-efficient investing. Ryan Katona, chartered financial analyst and consulting analyst at Russell Investments in New York, illustrates the significance of crunching the numbers.
He cites the average capital gains distribution for U.S. equity mutual funds and exchange-traded funds that had a distribution in 2017 as being 8.4 percent of the fund’s net asset value. This distribution was split on average between 20 percent short-term capital gains and 80 percent long-term capital gains.
[Read: Beware of Phantom Income and the Tax It Brings.]
“Consider a hypothetical $500,000 taxable investment by an investor in the highest federal tax bracket,” Katona says. “An 8.4 percent capital gain distribution on the investment amounts to $42,000, which then gets taxed. Assuming the 20 percent short-term capital gains and 80 percent long-term capital gains proportion, that $42,000 distribution would result in a tax bill of $11,642.”
There is, however, a way to potentially reduce the tax drag.
“Tax-loss harvesting is a strategy for capturing capital losses that can be used to offset capital gains within a taxable account,” says Brad Kudick, senior financial advisor with U.S. Bancorp Investments in Milwaukee.
The error investors often make is assuming that tax-loss harvesting is something that can only be done once per year.
“In November or December, investors will scour their portfolio for annual tax-loss harvesting opportunities, looking for individual stocks that have gone down to sell,” says Mark Spina, head of Russell Investments’ U.S. advisor business, “but markets don’t always cooperate at the time when investors need them to.”
Monitoring your portfolio year-round for loss harvesting opportunities is the better choice from a tax-efficient investing perspective. Investors should work with their financial and tax advisors on regular tax reviews to determine if gains or losses should be taken, Kudick says. And don’t forget the wash-sale rule.
“An investor cannot repurchase the same or substantially identical security within 30 days of the sale,” he says. Doing so “eliminates the investor’s ability to use the loss to offset capital gains.”
Be proactive, not reactive. “One can’t simply rely on a wait-and-see approach when managing a taxable account,” says Michele Lee Fine, a retirement income certified professional at Strategies for Wealth in New York.
Fine emphasizes having standards in place for managing your position, including establishing a baseline for when it makes sense to buy or sell for maximum tax efficiency. She also advises against making investments without taking the long view.
“Buy positions you’re committed to holding for at least 12 months to obtain preferential long-term capital gains treatment,” Fine says. “If possible, avoid actively traded funds with high turnover, as that usually means greater realized short-term capital gains.”
Remember also that diversification matters, particularly for harvesting losses in a taxable account.
“There’s a fine line between being properly diversified and overly diversified,” MacDonald says. “If you own too many securities it becomes too hard to manage the portfolio and you tend to just get index returns. And if you own too little, you won’t be able to properly take advantage of tax loss harvesting.”
Finally, resist the urge to let market movements dictate your investment choices.
[See: 7 Classic Inflation Hedges and Their Thorns.]
“It’s important investors with taxable accounts have a long-term view and don’t get too excited when the market is up, or too nervous when the market is down,” Woods says. “Invest with logic and find a trusted financial professional to help you avoid any major tax bills.”
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Do’s and Don’ts of Tax-Efficient Investing originally appeared on usnews.com
