As CPA's, we understand the importance of protecting your portfolio with tax-efficient decisions during every stage of the investment process. We also recognize that poor tax planning can turn a great portfolio return into a mediocre return. Tax efficient investing is an essential component of financial planning, especially for high-net worth individuals, and we incorporate tax planning into all aspects of the process.
Although determining how much risk to take is the primary driver of asset allocation, a consideration of taxes is also important. When the investor has both taxable and tax-deferred accounts, the question arises of where should assets be located. The most common strategy is to place bonds and other income producing investments, which are taxed primarily at the ordinary income rate, in a tax-deferred retirement account and keep assets that are more amenable to tax management, like equities, in the taxable account. However, in many cases this is not the best approach. An investor’s taxable account usually has a much shorter investment horizon, greater liquidity needs, and lower risk tolerance than their retirement account. These differing horizons and risk preferences mean that, for most clients, locating assets in a particular account solely due to its tax characteristics is inappropriate. The correct strategy is going to vary from person to person depending on their independent circumstances.
There are five basic tax-management techniques we use to increase the tax efficiency of our portfolio. These are the building blocks for a comprehensive tax-management strategy:
Defer the realization of gains. This is the bread and butter of tax management. The government only taxes an investment gain if the asset is sold; the tax liability is deferred as long as you hold the asset. This is equivalent to receiving a zero interest loan from the government. The increase in the value of the investment has created a tax liability, but you can defer the payment of that liability indefinitely and allow that money to continue to compound over time. Because the cost basis of assets in an estate is reset at the taxpayer’s death, in some cases the “loan” will never be repaid.
Manage the holding period. Capital gains from the sale of a security are taxed as ordinary income unless the investment is held for longer than 12 months, and thus qualifies for a lower tax rate. Dividends are also taxed as ordinary income, but can qualify for a lower tax rate if the security is held for longer than 61 days.
Harvest losses. Selling a security whose price has fallen below its purchase price (the market value is below the cost basis) results in a realized tax loss. These losses may be used by the tax payer to offset realized capital gains. While many investors only harvest losses in December, this activity can be much more valuable if it is done throughout the year.
Pay attention to tax lots. Most managers that pay attention to taxes will use highest in, first out (HIFO) tax-lot accounting whenever a security is sold. This will reduce the tax impact of the sale and improve after-tax returns. In some cases, identifying specific tax lots can improve tax efficiency. For example, an investor with a tax-loss carry forward may find it beneficial to accelerate gains. Investors who need to generate cash flow from their investments or have charitable giving plans will benefit from a manager who pays close attention to tax lots.
Avoid wash sales. When a security is repurchased within 30 days of its sale, any loss realized cannot be used to shelter gains. Instead the loss is added to the basis of the new shares. This negates the benefit of loss harvesting. Policing wash sales is particularly challenging when constructing multiple manager portfolios.