By Carole C. Foos, CPA, and Andrew Taylor, CFP
Lawyers in the highest income tax brackets may have been presented with an unpleasant surprise in the last two years when they learn of their investment tax liability. A prolonged period of strong domestic stock performance, combined with the implementation of The American Taxpayer Relief Act of 2012 may have resulted in significantly higher taxes for you.
The top ordinary income tax rates increased by 24%, while the top capital gains rate was increased by more than 58%. Writing a large check to the Internal Revenue Service serves as a harsh reminder that tax planning requires attention throughout the year, and is not a technique you can properly manage one week out of the year.
Recent market volatility has resulted in domestic stocks experiencing a sell off of substance for the first time in four years. While most investors are understandably frustrated with their losses, savvy advisors are using the correction as an opportunity to re-position portfolios while reducing their clients’ tax bill at the same time.
Proper tax planning becomes more critical as we move into an era of higher taxes. Five years of a rising stock market resulted in many traditional investment vehicles holding large amounts of unrealized gains that can become realized gains if you are not careful. In this article, we will provide you with six suggestions that could save you thousands of dollars in investment taxes over the next several years.
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1. Account Registration Matters: If you are reading this article you likely have a reasonable amount of investment experience and have become familiar with the benefits of security diversification in your portfolio. However, a common mistake investors make is failure to implement a tax diversification strategy. Brokerage accounts, Roth IRAs, and qualified plans are subject to various forms of taxation. It is important to utilize the tax advantages of these tools to ensure they work for you in the most productive manner possible. A properly integrated approach is critical during your accumulation phase. Further, it is just as important when you enter the distribution period of your investment life cycle. Master Limited Partnerships offer a potentially advantageous income stream for a brokerage account, while it is generally preferable for qualified accounts to own high yield bonds and corporate debt, as they are taxed at ordinary income rates. There are countless additional examples we could discuss, but the lesson is it is important to review the pieces of your plan with an advisor who will consider both tax diversification and security diversification as they relate to your specific circumstances.
2. Consider Owning Municipal Bonds in Taxable Accounts: Most municipal bonds are exempt from federal taxation. Certain issues may also be exempt from state and local taxes. If you are in the highest federal tax bracket, you may be paying tax on investment income at a rate of 43.4%. Under these circumstances, a municipal bond yielding 3% will provide a superior after tax return in comparison to a corporate bond yielding 5% in an individual or joint registration, a pass through LLC, or in many trust accounts. Therefore, it is important in many circumstances, to make certain your long-term plan utilizes the advantages of owning certain municipal bonds in taxable accounts.
. Be Cognizant of Holding Periods: Long term capital gains rates are much more favorable than short term rates. Holding a security for a period of 12 months presents an opportunity to save nearly 20% on the taxation of your appreciated position. For example, an initial investment of $50,000 which grows to $100,000, represents a $50,000 unrealized gain. If an investor in the highest tax bracket simply delays liquidation of the position (assuming the security price does not change) the tax savings in this scenario would be $9,800. Although an awareness of the holding period of a security would appear to be a basic principal of investing, many mutual funds and managed accounts are not designed for tax sensitivity. High income investors should be aware that the average client of most advisors is not in the highest federal tax bracket. Therefore, it is generally advantageous to seek the advice of a financial professional with experience executing an appropriate exit strategy that is aware of holding periods.
4. Proactively Realize Losses to Offset Gains: As mentioned in the opening paragraph of the article, 2015 has presented investors with an opportunity to realize losses in domestic stocks for the first time in four years. Clients with a diversified portfolio, likely had this opportunity in prior years. One benefit of diversifying across asset classes is that, if the portfolio is structured properly, the securities typically will not move in tandem. This divergence of returns among asset classes not only reduces portfolio volatility, it creates a tax planning opportunity. Domestic equities experienced tremendous appreciation over a five year period through 2014; however international stocks, commodities, and multiple fixed income investments experienced down years. Astute advisors were presented with the opportunity to save clients thousands of dollars in taxes by performing strategic tax swaps prior to yearend. It is important to understand the rules relating to wash sales when executing such tactics. The laws are confusing, and if a mistake is made your loss could be disallowed. Make certain your advisor is well versed in utilizing tax offsets.
5. Think Twice About Gifting Cash: This is not to discourage your charitable intentions. Quite the opposite is true. However, a successful investor can occasionally find themselves in a precarious position. You may have allocated 5% of your portfolio to a growth stock with significant upside. Several years have passed, the security has experienced explosive growth, and it now represents 15% of your investable assets. Suddenly your portfolio has a concentrated position with significant gains, and the level of risk is no longer consistent with your long term objectives. The sound practice of rebalancing your portfolio then becomes very costly, because liquidation of the stock could create a taxable event that may negatively impact your net return.
By planning ahead of time, you may be able to gift a portion of the appreciated security to a charitable organization able to accept this type of donation. The value of your gift can be replaced with the cash you originally intended to donate to the charitable organization and, in this scenario; your cash will create a new cost basis. The charity has the ability to liquidate the stock without paying tax, and you have removed a future tax liability from your portfolio. Implementing the aforementioned gifting strategy offers the potential to save thousands of dollars in taxes over the life of your portfolio.
6. Understand your Mutual Fund’s Tax Cost Ratio: The technical detail behind a mutual fund’s tax cost ratio is beyond the scope of this article. Our intent today is to simply bring this topic to your attention. Tax cost ratio represents the percentage of an investor’s assets that are lost to taxes. Mutual funds avoid double taxation, provided they pay at least 90% of net investment income and realized capital gains to shareholders at the end of the calendar year. But, all mutual funds are not created equally, and proper research will allow you to identify funds that are tax efficient.
A well-managed mutual fund will add diversification to a portfolio while creating the opportunity to outperform asset classes with inefficient markets. You do need to be aware of funds with excessive turnover. An understanding of when a fund pays its capital gains distributions is a critical component of successful investing. A poorly timed fund purchase can result in acquiring another investor’s tax liability. It is not unusual for an investor to experience a negative return in a calendar year, yet find himself on the receiving end of a capital gains distribution. Understanding the tax cost ratios of the funds that make up portions of your investment plan will enable you to take advantage of the many benefits of owning mutual funds.
The above steps are by no means the only tax strategies experienced advisors can execute on behalf of their clients. This article highlights several strategies you should discuss with your advisor to determine if implementation is appropriate for your unique portfolio and overall financial situation. Successful investing requires discipline that extends beyond proper security selection. While gross returns are important and should not be ignored, the percentage return you see on your statements does not tell the full story.
In today’s tax environment, successful investors must choose an advisor who will help them look beyond portfolio earnings and focus on strategic after-tax asset growth.
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arole Foos is a Principal of OJM Group, and aCertified Public Accountant (CPA) offering tax analysis and tax planning services to OJM Group clients. Carole has over 20 years of experience in public accounting in the field of taxation. She was formerly a manager in the tax department of a Big 4 firm and spent several years in public accounting at local firms. She has been a tax consultant to both individuals and businesses providing compliance and planning services over the course of her career. In addition to her work for OJM, Carole maintains a tax practice in Cincinnati. She is a co-author of the books For Doctors Only: A Guide To Working Less and Building More, For Doctors Only: Highlights Edition and Fortune Building for Business Owners and Entrepreneurs, along with state specific editions in the For Doctors series.
ndrew Taylor is a Wealth Advisor with 19 years of experience working with affluent individual investors. His career in the financial industry has focused on providing customized investment management, and comprehensive wealth planning in a tax efficient manner for his clients. Prior to joining OJM Group, Andrew spent 13 years at Charles Schwab & Co. managing and growing a substantial practice in the greater Cincinnati area, and working with local attorneys and CPAs to implement integrated wealth planning for his clients. Andrew’s experience includes time as a Retirement Consultant at Fidelity Investments, where he provided strategic planning solutions for individuals experiencing a career transition.
They can be reached at 877-656-4362 or .
