Tax-Wise Investment Planning: Advanced Strategies, Part II

As described in our last Wealth Extractions article, “Tax-Wise Planning for Retirement, Part I”, planning for the financial outcomes you desire can be a little like a pilot creating a flight plan for his or her intended destination.

If unmanaged taxes knock your investment plans off course by a few degrees, you may never reach your ultimate goals.

Here are a few tactics for remaining on course.

Asset Location for Tax Minimization

How are your investments like your house?

In both cases, “success” can often be attributed to three things: location, location, and location.

Asset location involves carefully dividing your different types of assets among tax-favored and taxable accounts to maximize the after-tax return of your overall portfolio.

It stands to reason, if an asset is expected to generate more taxable events, it’s best to place it in a tax-sheltered account when you’re able, where the events can become non-events.

For this reason, as a broad (very broad) rule of thumb, we generally advise holding stocks/equities in taxable accounts, leaving your tax-advantaged accounts for holding your REIT (Real Estate Investment Trusts) funds, commodity funds and fixed income/bond investments, in approximately that order of priority.

Overall, equities are more tax-efficient than these other asset classes.

There also are some estate planning – and charitable planning benefits – to this approach, such as the ability for securities to receive a step-up in basis for the heirs at death or charities upon donation, effectively eliminating the capital gains accrued.

However, there are plenty of exceptions and variations on the theme.

Throw in considerations — such as liquidity needs; foreign investments, which give us the ability to utilize foreign tax credits against our federal income tax; equity asset classes with very different tax characteristics (such as emerging market stocks versus large-cap growth stocks), which have very different tax characteristics; and ever-evolving tax code revisions. — And suffice it to say, it can get pretty messy, pretty fast.

It pays to seek expert counsel as you proceed.

Consider the case of Dr. Smith, who has a total portfolio of $1.75 million comprised of $400,000 in a taxable account and $1.35 million in a rollover IRA.

Allocated 70 percent stocks/30 percent bonds, Dr. Smith has $1.225 million in stocks, including funds holding real estate and commodities, plus $525,000 in bonds.

How do we best allocate this portfolio between the taxable account and IRA?

Given these numbers, it is easy to see that all the bonds will fit in the retirement account.

In addition, we have room in the IRA for the REIT fund (Real Estate Investment Trust) and the commodities fund, neither of which are tax-efficient asset classes.

Accordingly, it makes sense to have the most tax-efficient asset classes in the taxable account – those being the US large-company stock fund plus some international funds, so we can use the foreign tax credits generated by the fund on Dr. Smith’s tax return. (The funds pay taxes in the countries where the stocks are traded and our government gives us credit for those foreign taxes paid … but not if the funds are held in a tax payer’s tax-sheltered account. In that case, the credit goes unused.)

Figure 1 provides a visual of how all of this might be allocated within Dr. Smith’s overall, tax-
efficient and well-diversified portfolio.

Tax-Efficient Investing

For your taxable, personal savings account, there’s an additional, significant step you can take: select tax-managed funds, or low-cost, passively managed mutual funds that additionally manage with an eye toward maximizing after-tax returns.

Tax-managed funds typically take a number of actions accordingly.

They use strategies that you, as an individual taxable investor, can also take with your own trading activities for a double-whammy of benefit.

For example:

  • Engaging in tax lot accounting, selling highest-cost shares first
  • Matching of Pairing gains and losses; – waiting to realize necessary capital gains a little longer than normal might otherwise be the case if waiting is expected to minimize the taxable impact
  • Avoiding realized capital gains when possible, particularly short-term (higher-taxed) gains
  • Managing dividends with a sensitivity to their tax implications
  • Engaging in additional patient buying and selling strategies to avoid unnecessary, taxable transactions
  • Maintaining broad diversification to avoid company-specific risk

Tax-Loss Harvesting

While you’re unlikely to rejoice when one or more of your assets are priced at less than what you paid for them, there is a silver lining in that cloud, in that it offers you the opportunity to consider tax-loss harvesting.

Tax-loss harvesting is the act of selling an asset at a loss and using the loss to offset taxable gains on other investments.

Like credit in the bank, you can apply the loss in either the current tax year or moving forward.

Consider the true story of our client illustration of Dr. Jones, who had accumulated a sizeable taxable account in addition to her retirement plan by the time she was thinking of retiring.

When the market went down so dramatically in late 2009 and early 2010, her advisor helped her harvest $170,000 worth of losses in her accounts (while temporarily shifting the assets elsewhere within the market so she could remain invested according to her long-term investment plans).

She sold her practice in December of 2010 and was able to use that loss to offset the gain on the sale of her a highly appreciated asset she’d held, thereby saving about $40,000 in taxes.

By working with an advisor who views her portfolio as a whole, and efficiently manages the tax losses and gains within its parts, Dr. Jones can seek to proactively enhance her overall outcome.

But again, while the concept is simple enough, there are plenty of rules, regulations, and circumstances to be weighed in assessing when and how a tax-loss harvest is most likely to work in your favor.

Generally speaking, we help investors realize tax losses when the loss is substantial, i.e., when the benefit it offers is expected to significantly outweigh the trading costs involved.

We also consider market conditions at the time.

Because of IRS “wash sale rules,” harvesting a loss requires you avoid repurchasing the same or any “substantially identical” asset for a minimum of 31 days after the sale.

So you face the risk that the asset will surge back during that month, resulting in your missing out on the gain.

In volatile markets, assessing the potential risks and rewards can be a delicate judgment call.

Keeping Your Destination in Mind

There is at least one way in which flight and finances are not the same.

While I often hop in my Cherokee Six aircraft for the sheer pleasure of the ride, that’s not how we advise you to consider your investment activities.

With your wealth, the fun part really should be the destination, your financial goals and life aspirations achieved.

That means that your measure of success is the real wealth you’ve got to fold up and put in your proverbial wallet at the end — after you’ve paid the tax man.

Clearly, there are plenty of actions you can take to maximize your after-tax returns, as described above. At the same time, many of these activities can backfire if they’re not properly managed.

Working alongside a wealth manager co-pilot who is well versed in the devilish details can be well worth it to your bottom line.

Best wishes on your financial journey.