By Carrie Coghill, CFP.
Tax season is finally over and we are all feeling a sense of relief! Typically, the last thing that people want to think about after April 15th is their income taxes for the following year. However, now is exactly the time that you should be thinking about next years’ taxes. The typical question most people want to know is “Do I owe?” or “Am I getting a refund?” The more appropriate question should be, “What can I do to improve my tax situation for next year?” Waiting until December to do your tax planning is like waiting until you’re sick to start taking vitamins. You need to have time to prepare throughout the year. But, exactly, what are you looking for and how does it apply to your investment portfolio?
Ultimately, the productivity of your investment portfolio should be measured on an after-tax basis. How much ends up in your pocket after you pay Uncle Sam? It may be less than you think, especially with all of the intricacies of the alternative minimum tax which limits the benefits a person can receive from the favorable tax treatment of certain items. If the alternative minimum tax calculation results in a higher tax than regular income tax, the difference is added to regular income tax on Form 1040. From an investment perspective, it is critical that you work with your financial advisor and accountant to determine the after-tax return on your investments. For example, if you earned eight percent on your investments, you may find that your net-after tax return is much lower. Although the tax reform act of 2001 reduced tax rates on income, capital gains and dividends, the phase-out of many deductions and the alternative minimum tax may ultimately have a negative effect on your overall tax situation.
The challenge that investors face is the ability to effectively manage the tax consequences of their portfolios without swaying from the basics of successful investment practices. For example, seeking proper diversification and professional management can be critical factors in the success of an investment strategy.
Diversification helps to reduce overall risk. We’ve all heard the saying “don’t put all of your eggs in one basket.” Diversity among different asset classes (stock, bonds, real estate, etc.) and within these specific asset classes are the foundation of sound investment management. For example, if it is determined that you need to have 40 percent of your portfolio invested in stocks, don’t put 40 percent into Microsoft. Diversify among several different stocks and categories of stocks.
For many investors, seeking out professional investment management can also be a critical element in achieving financial success. Unless you have the time and the expertise to understand investing and economics, seek out a professional advisor. Speaking from experience, my clients know that they can make more money focusing on their respective profession rather than trying to learn the profession of money management.
When analyzing your portfolio from a tax perspective, remember the importance of diversification and professional management. The next logical step is to identify the investment vehicles that make the most sense for your specific situations. One of the most frequently asked questions I get from people is, “Should I own individual stocks?” For the most part, the answer to this question usually comes down to, “Taxes.” Mutual funds offer a package of professional management and diversification. Your money is pooled together with other investors and a professional money manager makes all of the buying and selling decisions. In essence, a stock mutual fund is a portfolio of individual stocks.
So, why not just use a mutual fund? The manager of a mutual fund is managing the portfolio to achieve the best results for its shareholders. The trading within a mutual fund is done without regard to your specific income tax situation. Although many mutual fund managers try to minimize the tax consequences, the degree to which you are responsible for capital gains taxes can vary, greatly, from one year to the next. Mutual funds pass through all of the income and capital gains to shareholders, but cannot pass along losses. In additions, shareholders typically aren’t aware of these tax consequences until late in the year. Many funds wait until December 31st to make their capital gains distribution. That doesn’t give the investor too much time to make adjustments.
On the other hand, an individual stock portfolio does give you the ability to manage your income tax consequences. In addition, when decisions are made, you are aware of the tax consequences and can properly plan to either withhold money or offset the gain with a loss (if available). The challenge with individual stock portfolios is that you must hire the professional manager, instead of relying on a mutual fund company to do so. A professional money manager should have the expertise to properly diversify your stock portfolio and manage the portfolio to achieve the best after-tax returns.
Owning individual bonds versus bond funds also provides investors with the flexibility to select bonds that are best suited for their individual goals and tax situation. When using fixed-income investments to fund specific goals, individual bonds provide the ability to ensure the money will be available at the time it is needed. Bond mutual funds fluctuate as interest rates change. Therefore, in a rising interest rate environment, the value of your bond fund may decline, with no guarantee of recovery. Plus, in a taxable bond fund, you are required to pay income taxes on the dividends earned, even if your principal has gone down. With individual bonds, although the price fluctuates, at maturity, the promise is that you will get your money back.
The biggest advantage to owning individual securities versus mutual funds is the flexibility to buy and sell securities in a manner that is suitable to your specific tax situation. Below are four considerations for tax efficient investment management.
Balancing capital gains with capital losses. If you sell a security and incur a tax gain, you maintain the ability to sell another investment that may be in a loss position; thereby offsetting the gain. The result is the reduction or elimination of capital gains tax.
Creating a strategy that spreads tax consequences over several tax years. If you have a security that will generate a large tax consequence, consider selling portions of the security over different tax years. In addition, various “stock option” strategies can be implemented in order to protect from the decline in a stock position while you are divesting the position.
Consider lateral moves. If you have a stock that is in a loss position, but still like the future prospects of the company, consider selling the stock and moving it into a comparable stock within the same industry. After 30 days, you can move back into the stock. It is important to recognize that you must wait 30 days, otherwise the loss will not be allowed.
Other tax events. Be sure to consider your overall tax situation each year when designing your investment portfolio. Other events, such as a change in marital status, charitable contributions, purchase or sale of a home, etc., may impact the tax rates applied to your investments.
As you can see, individual securities portfolios offer many advantages; however, mutual funds can serve a very important purpose in an investment portfolio. Specifically, they can provide access to investment categories that may be difficult to research and acquire in the form of individual issues. These categories may include: international markets, commodities, real estate, long-short funds, etc. Some of the best money managers in the world manage mutual funds and may fit a specific need within a portfolio. Typically, we find that a mix of individual securities, along with mutual funds may provide a good balance between achieving performance results while managing tax consequences.
Ultimately, every investment decision you make should be analyzed on an after-tax basis. Now is the perfect time to review your investments and understand the tax consequences of each one in order to ensure that your financial goals will be met.
Carrie Coghill, CFP is President of D.B. Root & Company Financial Planning based in Pittsburgh, Pa.