Wealth of Knowledge - November 2011 - Maximizing Portfolio Return on an After-Tax Basis
There are only so many factors that can be controlled by the investor in an effort to maximize after-tax returns. No one can consistently predict the timing of the peaks and troughs of the market cycle; however, reducing portfolio costs and tax exposure can be controlled. Following are a few suggestions and observations on how to minimize taxes generated in your portfolio.
Year-End Tax Loss Harvesting
As you approach the last two months of each calendar year, it is wise to review and quantify your year-to-date realized short-term and long-term capital gains. If you are facing a large amount of realized gains and do not have a substantial loss carry forward from prior years, your investment advisor can review individual tax lots to harvest any unrealized losses, to offset the realized gains. The one rule to be aware of is the Wash Sale Rule. The Wash Sale Rule applies when a capital loss is realized from the sale of a stock or security. The realized capital loss cannot be deducted for federal tax purposes if you had purchased the same investment, or substantially identical security, within 30 days before or after the sale of the stock or security. A common technique that is used to avoid violating the Wash Sale Rule and maintain market exposure is the use of an Exchange Traded Fund (ETF) as a substitute for an individual stock. For example, a loss on a large cap value stock is recognized by selling the position, with the proceeds invested into the Russell 1000 Large Cap Value ETF; the index fund must be held for 31 days before it can be sold and the individual stock repurchased (assuming it is still an attractive investment). Make sure to check your individual state tax regulations. New Jersey for example does not allow capital loss carry forwards. In general, New York does allow loss carry forwards for individuals as recorded on IRS Form 1040 Schedule D.
Mutual Funds with Large Year-End Capital Gains Distributions
Many mutual funds tend to pay out their capital gain distributions in December by way of a dividend. It is a common practice for funds to publish estimates for year-end capital gain distributions before a dividend is declared. If funds are expected to pay out a large dividend (especially short-term capital gains that cannot be netted against realized losses) before year end, you can sell the fund before the ex-dividend date. Begin by checking with the funds you hold (via the funds' investor help lines or websites) towards the end of November, to see if estimates for capital gain distributions are available. If you recognize a loss, the Wash Sale Rule applies to mutual funds as well with regard to repurchasing the fund within 30 days.
You should also consider the implications of mutual funds' year-end capital gain distributions if you are adding to an existing fund position, or opening a new position. You should ask yourself the following question: Why buy a mutual fund the first week of December, if it has been accumulating capital gains throughout the year (that you did not participate in) and paying these gains out in a dividend in the next few weeks? Rather than just sitting in cash and waiting until after the capital gains are distributed, you may want to consider buying an exchange traded fund to have market exposure. Once the capital gains have been paid, you can then sell the ETF and buy the mutual fund.
Highly Appreciated Stock Positions
If you were lucky, smart enough, or had a crystal ball that prompted you to buy Apple stock towards the end of December 2008 when the stock market was in turmoil, you probably paid somewhere in the ballpark of $85 per share. If you still hold the same lot of Apple stock on July 26, 2011, the current market price is around $400 per share. If you purchased 500 shares, your cost basis is $42,500 with a current market value of $200,000. The unrealized capital gain is $157,500. With the extension of the Bush-era tax cuts, the 15% long-term capital gain tax would be more than $23,600 for federal tax purposes if the Apple stock was sold on July 26, 2011. If you are charitably inclined, you could donate the highly appreciated stock in kind to a qualified charity; as a result in general, you will be able to take a charitable deduction on the fair market value of the stock (subject to adjusted gross income and charitable donation limitations) and avoid having to pay capital gains tax since the stock is gifted in kind to a qualified charity. You should also consider state income tax rules and rates.
Whether you have a mutual fund or separately managed account, managers with high portfolio turnover could end up realizing a substantial amount of net short-term capital gains. The net short-term gains are taxed unfavorably as ordinary income under current law, up to a maximum 35% federal rate. In addition to unwanted potential tax consequences, high portfolio turnover has hidden transaction costs that can erode portfolio return. When researching an active manager, look for low portfolio turnover. There is no specific rule, but in general a manager with less turnover will be more tax efficient than a manager who trades frequently. If turnover is less than 30%, the manager is more than likely to be tax efficient and incur less transaction costs. A manager with turnover less than 50% to 60% is still probably modestly tax efficient.
Exchange Traded Funds
If you are striving for maximum tax efficiency and low costs, you may want to consider passively managed ETFs. In general, ETFs have low expense ratios (costs) and lower turnover than active fund managers. ETFs trade like a stock throughout the day and generally are a diversified basket of securities that track a specific index or asset class. If you invest in ETFs, before purchasing, check how the specific investment vehicle reports taxable income. Most ETFs report shareholders' income on IRS Form 1099. However, some ETFs report income in IRS Schedule K-1, which has the possibility of complicating the preparation of an individual or joint tax return.
If retirement assets constitute a substantial portion of your investment portfolio, it is important to have the correct asset classes or investment vehicles in those accounts. For example, assume you have a $10 million portfolio ($7M in taxable assets and another $3M in a Roth IRA). Your target allocation is 60% equities and 40% fixed income. Based on your risk tolerance, time horizon, retirement and life expectancy, targeted investment return, and other factors, the following asset classes are selected: 30% U.S.large cap, 10% U.S. small cap, 15% international equities, 5% emerging markets, and 40% domestic fixed income. One way to construct the portfolio is to use high credit quality municipal bonds in the taxable accounts, since the income is generally tax free from federal income tax. The municipal bonds will generate income for living expenses and minimize taxes. Also, be sure your bond manager avoids private activity municipal bonds as they can expose you to the Alternative Minimum Tax (AMT). Your least tax efficient assets are typically the more volatile - emerging markets, then international equities, and U.S. small cap. These asset classes would be invested within the Roth IRA. The more tax efficient equity, U.S. large cap will be invested in the taxable account. If you are employing both active and passive investments, try to keep your active managers in the tax deferred account and the more tax efficient passive investments in your taxable accounts.
One issue to consider when allocating your most volatile assets to a retirement account is required minimum distributions (RMDs). RMDs generally begin in the year after you turn age 70½, as a result, the first year's distribution may be deferred until April of the year following the year you turn 70½. If you are already taking RMDs, or are close to the starting age, consider allocating a portion of your traditional IRA to taxable fixed income, or cash, to cover at least one year's distribution.
Since RMDs are taxed as ordinary income, consider fulfilling some or all of your minimum distribution requirement by gifting directly from your IRA to a qualified charitable organization. A maximum of $100,000 of your required minimum distribution to a qualified charitable organization can be exempt from ordinary income for federal tax purposes.
The tax impact on an investor's return is simply too great to ignore. There are multiple strategies that can be used throughout the year to reduce taxes generated by your portfolio. Minimizing taxes and maximizing return should always be a question in the minds of taxable investors.
EisnerAmper's A Wealth of Knowledge - November 2011: