Diane Pearson recently met with a client who was upset about the amount of taxes he had paid on investment gains in 2013.
“He wanted to know why his stock funds, which reported substantial taxable gains, were held in his taxable account,” says Pearson, personal CFO with Legend Financial Advisors in Pittsburgh.
The answer, Pearson says, is that her firm has a policy designed to maximize long-term after-tax returns. “Bonds and other fixed-income holdings go into tax-favored accounts such as IRAs,” she explains, “where the current interest income won’t be taxed.” (Municipal bonds and muni funds don’t belong in IRAs or similar accounts because interest that would otherwise be tax-exempt will be taxed on withdrawal.)
Clients’ equities, on the other hand, go into taxable accounts, where capital losses can be realized, when appropriate. Only $3,000 of net capital losses can be deducted each year but excess losses can be carried over indefinitely.
“We often hear from clients’ CPAs,” Pearson says, “wondering why we took so many losses that can’t be used right away.” She responds by pointing out that having a bank of losses gives her firm more freedom to handle clients’ portfolios—they can take gains where such moves fit into their investment strategy, while yesterday’s losses can reduce or offset the tax on today’s realized profits.
“With equities in a taxable account,” Pearson says, “stock dividends and any net long-term capital gains can receive favorable tax rates.” Depending on the client’s income, such payouts and gains will be taxed from zero to 23.8%. If the stocks or stock funds were held in an IRA, dividends and gains effectively will be taxed at ordinary tax rates up to 39.6% upon withdrawal.
If Pearson’s firm believes that taxable fixed-income assets typically should go inside an IRA while equities go into taxable accounts, which is the better place for investments that don’t fit neatly on either side?
“We have been using some managed futures limited partnerships,” she says, “which we try to put inside retirement vehicles. These investments use Schedule K-1 for tax reporting, which can add expense and complexity that we prefer to avoid.” If managed futures funds are held in a retirement account, tax reporting usually is not required.
Legend also uses some “liquid alts,” widely available hedge-like entries such as long-short funds. Where do they fit? “That can be hard to tell,” Pearson says, “so we look at funds on a case-by-case basis. We examine each one’s history of taxable distributions to determine the most tax-efficient place to hold a fund.” If a fund is managed so that it typically pays out significant amounts to investors, a tax-advantaged retirement plan may be an ideal home.
Pearson says that some clients have most of their assets in tax-favored territory while others mainly have taxable accounts, so the inside-out question isn’t crucial. Other clients, though, have their eggs spread among several baskets so it can pay to place their investment assets where they’ll benefit from cracking the tax code.
Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.