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Tax Planning


Putting the Puzzle Together



If you’re reading this article in early November, you have less than two months to use your investment portfolio strategically to minimize the taxes you’ll owe for this year.

Considering tax liabilities just before the holiday shopping season is about as much fun as getting your teeth drilled.  But if you want the chance to improve your tax position — and to be honest, who wouldn’t? — now is the time to take a hard look at your portfolio.  By carefully harvesting losing positions or selectively selling certain lots of stocks with capital gains, you can not only offset capital losses with capital gains but also potentially reduce your overall tax bill.

And while you’re at it, it’s a good idea to examine your entire portfolio from a tax perspective.  Although tax considerations shouldn’t drive your portfolio management decisions, paying attention to tax rates on various types of income and constructing your portfolio around these issues can help reduce taxes and maximize gains in the future.

Taking this a step further, analyzing your overall asset allocation for tax consequences can add a tool to your portfolio management toolbox.  A portfolio’s after-tax asset allocation will differ from its pre-tax allocation and can make a difference when determining risk, returns and the location of your assets.

“When you determine your asset allocation using the traditional approach, which doesn’t factor in taxes, you’ll end up exaggerating the bond aspect of the portfolio and underestimating the equities portion of the portfolio,” says William Reichenstein, professor of finance and the Pat and Thomas P. Powers Chair in Investment Management at Baylor University.  “If you rebalance your portfolio based on those inaccurate numbers, you’ll get it wrong.  And if you’re going to rebalance, let’s get it right.”

Tax decisions shouldn’t outweigh fundamental investment analysis when buying and selling stocks.  But individual investors and investment clubs shouldn’t ignore the return-enhancing role the tax code provides.  If you can improve your gains and reduce your losses through tax-sensitive investing, it makes sense to try it.

Tried and True Strategies
For individual investors, there are a number of well-known — and not- so-well-known — tax strategies to consider.  These include:

•    Harvesting gains and losses.  You’re no doubt familiar with the IRS provision that allows you to offset any capital gains with capital losses.  So if you sell a stock that has a long-term capital gain of, say, $2,000, it might be worth your while to sell a poorly performing stock to offset the gain.  If the poorly performing company is fundamentally sound, you can always buy it back after 31 days; if not, you’re most likely better off without it anyway.  You can also deduct up to $3,000 of losses against ordinary income and carry forward to future tax years any losses that you take but can’t use this year to offset either gains or ordinary income.

•    Weighing long-term vs. short-term gains.  This isn’t much of an issue for buy-and-hold investors, but it’s still worth knowing about.  If you have a stock that has appreciated significantly and the fundamentals are crying sell, it may be worthwhile to postpone selling the stock until a full year has passed since you purchased it, especially if you’re not too far away from this date.  “If you buy a stock, be prepared to hold it for a period longer than 12 months, because any gain realized on that holding will be taxed at the long-term capital gains rate of 15 percent,” says Bill Keller, director of investment for PNC Wealth Management.  “Shorter holding periods will be taxed at ordinary income tax rates.”

•    Identifying specific lots when selling.  This method is a bit more tricky and time-consuming but well worth the effort.  “The IRS allows you to designate which shares you’re selling if selling a portion of a position,” says Bill DeShurko, a Certified Financial Planner and author of The Naked Truth About Your Money (Penguin, 2007).  “If you buy 100 shares at $10 and later buy 100 more at $12, and then you sell 100 shares at $15, you can choose which ‘lot’ of 100 you sold.”  So if you inform your broker in writing before the sale that you’re selling the lot acquired at $12 per share, your tax will be lower than if the broker just averaged the cost, which is what happens if you don’t specify a lot in advance.

For the tax years 2008 to 2010, taxpayers in the 10-percent and 15-percent tax brackets can take advantage of zero-percent capital gains tax rates, according to Jim Ivers, a professor of taxation at the American College in Bryn Mawr, Pa.  Because of the way the tax is calculated, even taxpayers and retirees with incomes up to $85,000 may be able to take advantage of this three-year window of op-portunity for the zero-percent rates.

Effect on Returns and Allocations
As Reichenstein notes, it’s important to get asset allocation percentages and returns calculated correctly.  However you benchmark your returns — whether by an index or by a personal rate you want to achieve over the long term — make sure you get it right.

Tax-adjusted total returns.  If you or your investment club uses software or Web tools such as Club Accounting 3, Bivio or BetterInvesting’s Portfolio Manager, you can determine the pre-tax return easily enough by checking out a portfolio’s internal rate of return.  The IRR basically accounts for additional contributions you make in a portfolio over time.  Many financial services companies will provide this information for your personal portfolios.

Once you have an accurate internal rate of return, go to a calculator that helps you determine after-tax investment returns at Yahoo! Finance (the URL is listed at the end of this article).  After inputting your IRR or the projected return on investments in the future, your state and federal marginal tax rates and the assumed inflation rate, you’ll see a graph of the difference between your pre-tax and after-tax rates of return along with your inflation-adjusted purchasing power.

Tax-adjusted asset allocation.  Figuring out your tax-adjusted asset allocation is a similar process, Reichenstein says.  Again, you need to know your tax rate so that you can convert the funds in a tax-deferred vehicle such as an IRA or a 401(k) to their after-tax values.  Under this scenario, if you are in the 25-percent tax bracket and have an IRA worth $10,000, these funds are actually worth $7,500 in after-tax dollars.  If you calculate your asset allocation without taking taxes into consideration, your allocation will be skewed, leaving you with too much or not enough in the various asset classes.

Portfolio Management in Context
Investors are wise to consider tax issues when allocating assets among their various investment accounts.  Most investors have several ac-counts, including employer-sponsored retirement accounts such as 401(k)s and 403(b)s, IRAs, college savings accounts and taxable investment accounts — not to mention their spouse’s accounts.  Fortunately, there’s a relatively simple solution to managing multiple portfolios.

“Generally speaking, it makes sense to place investments that generate ordinary income taxes — such as bonds, bond funds and real estate investment trusts — into tax-deferred vehicles, because in a tax-deferred account you’ll end up paying ordinary income tax on anything you withdraw regardless of what type of asset it is,” says Marc Minker, CPA, director of the Family Office and Private Client Services Group for accounting firm Mahoney Cohen in New York City.  “In terms of appreciating assets such as stock and stock funds, there is very little value in placing those in a tax-deferred account, so it makes sense to place those in taxable accounts with more favorable tax treatment.”

Capital gains and dividend taxes are at historic lows — 15 percent for long-term gains.  So you’ll pay less taxes on assets with capital gains in a taxable account than if you put them in a tax-deferred account and paid ordinary income taxes on them on withdrawal.

The question of how to allocate your assets in light of tax consequences isn’t just an academic one.  Taxes hurt your returns and over the long-term can have a significant effect on them.

“There are a number of studies that show that taxes wipe out as much as 2.5 percent of your investment returns,” says Dan West, CPA, CFP, a partner with wealth management firm Moneta Group in St. Louis.  “This is why it makes sense to try to reduce the impact of taxes on your portfolio by employing strategies such as tax-lot selling and harvesting portfolio losses to offset gains.”

College savings accounts such as Coverdells and Section 529s are different because they’re exempt from capital gains taxes as long as funds are withdrawn for college-related expenses.  So you can use these ac-counts in a tax-neutral way because it really doesn’t matter what type of asset you hold within them.

Clubs and Taxes
Investment clubs traditionally haven’t paid that much attention to taxes because members are more focused on education, securities selection and portfolio management.  But ignoring tax consequences can be expensive for club members, says Ira Smilovitz, a longtime BetterInvesting member familiar with club accounting issues.  

“The thought process for managing individual investments in a tax-sensitive manner and managing club investments that way is different,” he says.  “It’s not intuitive or apparent even when it’s explained because of the complexity of the tax code.”

The most costly mistakes clubs make occur when they pay off a departing member and when they sell stock.  When paying off a departed member, too many clubs prefer to use cash, either by stockpiling member contributions or by selling stock.  

Stockpiling cash deprives clubs of the opportunity to follow their original purpose, which is to invest.  Meanwhile, selling stock — whether at a gain or a loss — can either trigger tax consequences for all the members or deprive them of the chance to have a tax loss, Smilovitz says.

The most tax-efficient way to pay off a departing member is by transferring stock that has appreciated in value or by giving the member cash from the sale of depreciated stock.  By transferring appreciated stock, clubs can avoid paying the capital gains on it; similarly, by selling stock that has lost value since the purchase, clubs can use a tax loss to offset investment gains.

Clubs can follow a tax-lot strategy when selling part of a position.  By keeping track of individual lots in club accounting, clubs can sell stock with the highest cost basis when a capital gain will be realized, minimizing the tax impact.  (Editor’s note:  Notice that we’re talking about selling a stock, as opposed to transferring it to a departing member, in this case.  When transferring a stock, clubs generally should transfer shares with the lowest cost basis.)  When selling a stock for a loss, the club can identify the lot with the biggest loss, maximizing the tax impact.

Just as with individuals, clubs must notify their broker in advance about which particular lot they’ll be selling to stay compliant with IRS rules.




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