Managing Portfolios for Higher After-Tax Returns
Taxes on investments in-creased for 2013, and there’s a good probability they’ll increase again at least for some of you. Some tax increases are direct, such as the increase in the rate on long-term capital gains and qualified dividends to 20% from 15%. Others are indirect, such as the Medicare premium surtax on higher incomes.
What’s clear is tax reduction is more important to increase wealth, and you need to be smarter and savvier about managing your portfolio to keep taxes low. As always, you don’t want to make an investment move solely for tax reasons. But you should take actions that will minimize taxes without changing your investment strategy.
One key strategy is to have investments in the right vehicles or accounts. I recommend tax diversification. We can’t know what future tax law will be, so it’s best to have the full complement of investment vehicles: taxable accounts, traditional IRAs, Roth IRAs, and any others that make sense for you, such as annuities.
When you have different types of accounts, to the extent possible match each account to the optimum investment for it. Here are general guidelines to follow:
Traditional IRAs and 401(k)s. These tax-deferred accounts should hold investments that generate ordinary income or short-term capital gains on a regular basis. Ideal investments for these accounts include most types of bonds, preferred stock, and real estate investment trusts. Stock mutual funds that do a lot of trading and generate taxable distributions each year also should be in these accounts. If you follow with part of your portfolio an investment strategy that generates a lot of short-term gains, such as our Invest with the Winners strategy, it’s best to implement the strategy through these accounts.
Taxable accounts. Assets that generate long-term capital gains or qualified dividends are best for these accounts. Mutual funds you hold for more than one year and that don’t have high annual distributions are ideal. Funds that have low turnover investment strategies usually have low annual distributions.
Stocks you plan to own for more than one year, especially those that pay dividends qualifying for the maximum 20% rate, also are good choices. You also can own in these accounts mutual funds that don’t meet these qualifications but that have large loss carry-forwards disclosed in their prospectuses. The loss carryforwards will shelter future gains. But be aware the loss carryforwards will disappear over time, after which the funds will generate taxable income.
Beware of purchasing for a taxable account a fund that has done extremely well the last few years and reveals high unrealized gains in the annual report. Services such as Morningstar also report on unrealized gains and losses. The fund at some point will take the gains. If it doesn’t have losses to offset them, the gains will be distributed to current shareholders.
Tax-exempt bonds of course should be held in taxable accounts.
Roth IRAs. Any investment that otherwise would be taxable can be held in a Roth IRA. It’s best, however, to use the Roth IRA for investments that would generate ordinary income or short-term gains. The same investments that would be best for a traditional IRA also are good candidates for a Roth IRA. If you have to choose between investments, it is best to hold the higher-returning one in a Roth IRA.
Here’s an exception to the general rules. When you expect to earn a substantially higher total return from a tax-advantaged asset such as a stock or mutual fund, it can be better to hold that asset in a tax-advantaged account, even if that means holding your bonds in a taxable account. My research shows that when the return from an asset or strategy exceeds the return from other assets by 4% or more, it makes sense to hold it in a tax-advantaged account, though that means giving up taxable account benefits such as the 20% long-term capital gains rate.
Your investment strategy comes first. Determine the best asset allocation for you. To the extent possible, own the assets as described here. But don’t let these guidelines cause you to avoid owning an investment or to change your allocation. To the extent you can, however, match investments with the optimum accounts for them.
Look for losses to take. A paper loss on an investment held in a taxable account is a valuable asset. When you sell the asset, the loss offsets dollar for dollar any gains you have for the year. When losses exceed gains, up to $3,000 of losses are deducted against other income. Any additional losses are carried forward to future years to be used in the same way.
Most people don’t do what’s called tax loss harvesting until the end of the year. That’s a mistake, because markets go up and down all year. After an investment takes a tumble and has a meaningful paper loss, consider selling it then to capture the tax benefits of the loss. You always can buy back the investment. To be able to take the loss and repurchase the investment, you have to wait more than 30 days to buy the identical or a substantially identical investment. But you can sell an investment, capture the loss, and buy another investment right away. For example, mutual funds generally aren’t considered substantially identical even if they follow the same strategy. You can sell one S&P 500 Index fund and buy an S&P 500 Index fund from another fund family.
Withdraw from the right accounts. The order in which you withdraw money from different types of accounts influences how long your nest egg lasts. My research, matched by research from others, shows that the right distribution strategy can extend a nest egg by several years.
The general rule is that you should draw down taxable accounts first. Let the tax advantages of traditional IRAs and Roth IRAs work for as long as possible. The nest egg lasts even longer when the taxable accounts are managed to minimize taxes, such as by taking advantage of tax loss harvesting, taking profits only as long-term capital gains, and earning income from qualified dividends instead of interest.
Another approach is to plan distributions from the different accounts to control your tax bracket each year. Take distributions from a traditional IRA, for example, until you’re pushed near the top of the 15% tax bracket. Then take additional distributions only by selling long-term capital assets and taking qualified dividends in taxable accounts. If you need additional cash, take it from a Roth IRA. This approach, while requiring more planning and work, can minimize lifetime taxes and also might reduce stealth taxes such as the Medicare premium surtax, inclusion of Social Security benefits in gross income, and the reductions in personal exemptions and itemized expenses.
Give charities appreciated assets. Cash contributions to charity often aren’t tax efficient. Instead of giving cash you can give appreciated assets such as mutual fund shares from taxable accounts. You deduct the fair market value of the shares on the date of the gift and don’t have to pay taxes on the gains earned while you held them.
If you still like the investment, you can use the cash you would have given to the charity to repurchase the asset. That increases the tax basis to the current value. So, your portfolio and asset values remain the same, but you no longer have the embedded tax bill from the gains earned during your holding period of the original shares.
Estate assets. These are assets or money you don’t expect to need and would like to leave to heirs. Most people make the mistake of designating a traditional IRA for this. That’s a mistake, because heirs still will owe ordinary income taxes on distributions from an inherited IRA. They’re really inheriting only the value of the IRA minus their tax rates. The IRS inherits the rest.
When a taxable account or an asset held outside of a traditional IRA is inherited, however, the heirs increase the tax basis to the fair market value on the date of the original owner’s death. All the appreciation during your lifetime never is taxed. Your heirs could sell the asset immediately and benefit from the full value. Or they can continue holding the asset and eventually owe taxes only on appreciation that occurs after they inherit.
RW May 2013.
