Compared with taxes, investing seems simple. As a CFP and CPA, a very large part of my practice is focused on maximizing tax efficiency, a strategy that often saves clients tens of thousands of dollars annually. With the higher 39.6% marginal tax bracket and the 3.8% passive income Medicare surtax in effect, tax efficiency is more important than ever.
I don't define tax efficiency as minimizing taxes, but rather as maximizing the return after taxes. For example, clients might be able to avoid taxes by holding municipal bonds - but if they are in a low enough tax bracket, they might keep more income after taxes by owning taxable bonds. That's the better goal.
Tax alpha comes from several sources, including:
* Product selection
* Asset location
* Tax-loss harvesting
* Roth conversion
* Withdrawal strategies
There are some general rules to follow for each of these sources. The one big caveat, however, is that everyone's situation is different - some clients may have huge tax-loss carryforwards, others may have nearly all of their portfolios in either taxable or tax-deferred assets. That means some circumstances require breaking these rules.
1 PRODUCT SELECTION
Product selection is one way to increase a portfolio's tax efficiency. At the most basic level, picking investment products for the long run avoids turnover. Whenever a client sells an asset in a taxable account, it generates a gain or loss with taxable implications. So holding on to assets with gains defers those taxes - that's like getting an interest-free loan from the government. Meanwhile, some investment products are more efficient than others. Mutual funds or ETFs that turn over their holdings generate taxable gains passed on to clients. According to Morningstar, the median turnover of active equity mutual funds is 49%. This creates both short-term and long-term taxable gains - and, by the way, tends to reduce returns even before these taxable consequences are factored in.
Index funds may also create turnover, particularly those with narrower focus. For example, a small-cap value index fund must sell when a company holding becomes larger or no longer meets the definition of value. Even an S&P 500 index fund must buy or sell whenever S&P makes a change.
The broadest stock index funds, such as the total U.S. or total international stock funds, have the lowest turnover and are the most tax-efficient. Even those funds, however, sometimes must sell to raise cash to buy large IPOs, such as Facebook or Twitter.
2 ASSET LOCATION
Once you help a client choose the appropriate asset allocation, location becomes critical. As a rule, tax-efficient vehicles belong in taxable accounts, while tax-inefficient vehicles belong in tax-deferred accounts, such as 401(k)s and IRAs. (Roth wrappers are much more complex - more on that in a bit.) The Asset Location Guidelines chart offers a general guideline for asset location.
There are several reasons to locate some stocks in taxable accounts. First, capital gains can be deferred indefinitely - by avoiding turnover - and possibly eliminated altogether, passing them on to clients' heirs with a step-up in basis. And dividends are taxed at 15% for most; even for those in the 39.6% marginal tax bracket, they still carry a 20% rate - lower than ordinary income.
By contrast, holding stocks or stock funds in tax-deferred accounts has three distinct disadvantages:
* It converts long-term gains into ordinary income, which increases the tax burden.
* Because stocks tend to be faster-growing assets, they create more ordinary income later, when the required minimum distributions will be larger.
* It could cause heirs to miss out on the step-up in basis.
What does belong in tax-deferred accounts? Slower-growing assets that are taxed at the highest rates. (Think taxable bonds.) Since REIT distributions are ordinary income, they also belong in the tax-deferred accounts.
One addendum: Although I believe muni bonds are overused, they would be held in a taxable account. Clients should not own stocks in a tax-deferred account while they have munis in their taxable account, however. They would likely earn more by holding the stocks in their taxable account and taxable bonds in their IRAs, and dropping the munis altogether.
What about Roth accounts? Although this is a complex subject (and very dependent upon individual situations), a general rule of thumb is that stocks and stock funds should be held in Roth accounts only when there is no more room (from an asset location perspective) in the client's taxable account. REITs are often properly located in Roth accounts.
There are many other variables that could change asset locations, of course, including whether a client plans to pass assets on to heirs or will sell them to raise money to live on.
3 TAX-LOSS HARVESTING
In late 2008 and early 2009, losses were plentiful and recognizing those losses created valuable tax-loss carryforwards. While only $3,000 a year can be recognized, an unlimited amount can be carried forward to offset future gains. With U.S. stocks at an all-time high as of mid-January, harvesting those losses even now is critical as equities are sold for any reason, including rebalancing.
When doing tax-loss harvesting, be sure to watch out for wash sale rules, making sure that clients don't buy back the same security within 30 days. To avoid having to exit stocks for a month when selling a broad stock index fund, consider buying a similar but not identical fund. For example, you could replace Vanguard Total Stock Index Fund ETF (VTI) with Schwab U.S. Broad Market ETF (SCHB). Because they follow different U.S. total stock indexes, this transaction should keep your client clear of wash sale rules.
It's never fun to harvest losses, but the silver lining to share with clients is that bad times don't last forever - and that there will come a time when those losses will save them a bundle.
4 ROTH CONVERSIONS
Roth IRAs and 401(k)s can be critical elements of your clients' portfolios. A common myth is that the Roth wrapper is better than the traditional account if the assets are held for a certain number of years. This is false. The only things that matter are the marginal tax brackets in the year of the conversion and the year of withdrawal. If the marginal tax bracket ends up higher upon withdrawal, the conversion will have been beneficial.
There's another factor: Since no one can be certain what lawmakers will eventually do, having three pots of money - taxable, tax-deferred and in a tax-free Roth - is an important way to diversify against unpredictable politicians.
Rather than have clients contribute to a Roth wrapper, I typically have them contribute first to a traditional retirement account, and then do multiple partial Roth conversions from existing IRAs to take advantage of potential recharacterizations later on.
I consider traditional IRAs to be partnerships between the client and the government. As an example: A $100,000 IRA owned by a client in the 30% tax bracket would be 70% owned by that client; converting it to a Roth costs the client $30,000 to buy out the government's share.
If that client does three $10,000 Roth conversions, he or she will owe $9,000 in taxes - $3,000 per conversion to buy out the government's share. If they put each $10,000 conversion in different asset classes early in the year, they'll have up to 15 months or (if the client files an extension) even up to 21 months to see how each performs. If, for example, the assets in one conversion tank and lose half of their value, the client can hit the undo button and recharacterize - thus having the government buy back its share at the full $3,000 original price.
Recharacterization also gives a client a chance to undo an unexpected impact from the dreaded alternative minimum tax. Tax accountants often underutilize the strategy of multiple Roth conversions - which can often be a vital part of tax planning.
5 WITHDRAWAL STRATEGIES
When clients transition from accumulation to withdrawal modes, tax strategy continues to be critical. There is a general rule of thumb that a client should spend taxable assets first, tax-deferred assets second and Roth assets last.
It's not a bad rule to start with, because spending down taxable assets lowers future income when clients will be withdrawing from tax-deferred accounts - which generally have a zero cost basis and generate ordinary income.
But the analysis becomes more complex if a client has an opportunity to pay taxes sooner at a lower marginal rate. If, for example, a client is retired but elects to delay Social Security until age 70 (a wise move for the healthy), a client may have more deductions than income. Thus, it would be advantageous to either take out enough money to stay within the 15% tax bracket ($72,250 for married couples filing jointly), or to do multiple Roth conversions to use up that low marginal tax rate.
From a broad perspective, advisors have a wide range of options to provide clients with tax alpha. Another example: Because most advisors don't get to design portfolios from scratch, they wind up keeping some existing assets while building a more diversified portfolio. So clients who come to me with S&P 500 funds and want to own a broader index - but have large unrealized gains that would create a tax hit if sold - can create a total index by using a completion index fund such as an extended market index fund, which owns every U.S. stock not in the S&P 500. Just by avoiding the sale of the S&P 500 fund, the client gains a tax advantage.
In most cases, coordinating with the client's CPA is critical. Since many CPAs do not have a strong understanding of investing, you may need to explain some of these strategies to them.
Tax strategy is far from simple - yet if done right, planners can create large amounts of tax alpha for clients in any phase of life.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo., and is a CPA. He also writes for CBS MoneyWatch.com and has taught investing at three universities.
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