If you’re like many Americans, you’ve started to consider (possibly even fear or dread) increasing tax rates on the horizon. Do you have taxable investments? Your tax burden may be even higher due to new Medicare surcharge on investment income. What’s an investor to do? Here are some real-life investing strategies to help you keep your tax obligations in check.
1. Municipal Bonds
Investors in state or local bonds may get to avoid federal (and sometimes state) taxes on ordinary income. This doesn’t exempt you from the Medicare surcharge but can go a long way to keep your tax burden in check. When you consider municipal bonds, look at their tax equivalent yield which helps to compare the bond yield to returns of taxable bonds.
2. Check Your Cost Basis Method
Your taxable brokerage accounts must have a cost basis method election. This determines how your original purchases are calculated against the closing price when securities are sold. Different methods may result in different tax consequences when a security is sold. If you’re in a high tax bracket, you might want to consider the Minimum Tax Method which works to result in the lowest tax consequences available for any given transaction. Not sure what’s best? A consultation between your CPA and financial planner might be best to make sure everyone’s on the same page with the best method for you, as I explained in my previous blog post.
3. Keep Turnover Low
When you buy and sell securities in your taxable investment accounts, there’s generally a tax consequence – either a realized capital gain or loss. Hopefully you’re realizing more gains than losses over time (that’s the point of investing), but you may want to analyze how often you’re buying and selling by calculating a turnover rate. A good rule of thumb is the lower the turnover the lower the tax burden, although, as with any rule of thumb, your personal circumstances need to be considered. Also, keep in mind the difference between short-term capital gains and long-term capital gains as you are rewarded for holding investments longer. You may want to wait until it’s been more than a year to sell something if you’re close.
4. Considerate Asset Location
If you have investment accounts with different tax characteristics, you have the opportunity to use asset location to your advantage. Let’s say you have a $500,000 Trust account (taxable) and $250,000 in an IRA. By placing types of investments that have higher tax burdens in the IRA account where your taxes are deferred, you can reduce the overall tax burden of your portfolio and hence increase your after-tax return. What types of investments may have higher tax consequences? Those with high turnover, taxable bonds, strategies that result in a lot of short-term gains to name a few. If you’re going to use asset location strategies, you may need to be ready to have different types of returns between accounts since they house different types of investments – focus on the overall investment performance of your combined accounts rather than whether one account trails another in any given time period.
5. Harvest Losses When Appropriate
Not every investing environment is positive and not every investment goes up and down in tandem with everything else. A small silver lining to an investment that has lost money is that you can typically tally a loss to offset a realized gain in your portfolio. If your realized losses exceed your realized gains, you should get to carry them forward for a future tax year. Some investments may be desirable long-term but present an opportunity to realize a loss in a shorter time period. In this circumstance, your financial planner can work with you to harvest the gain while avoiding a wash sale (re-entry into the same investment within 30 days) while staying focused on the same long-term strategy. Historically, investment managers might look to harvest losses in the 4th quarter as they were closing up the books for a calendar year. I often prefer to recommend a rolling review of unrealized losses so that you can uncover losses more frequently and with the movements of the market.
A note of caution: With all this talk focused on taxes, don’t forget that getting taxed usually mean that the investment has made you money. Stay focused on the big picture while staying aware of tax consequences. Don’t let tax tail wag the total return dog.
As you prepare for higher tax burdens, work closely with your financial planner and CPA to coordinate your investing strategy. There are trade-offs to be considered and your overall financial goals need to take first priority. With planning, though, some tax-focused strategies can help to keep your obligations within your control.
Melissa Joy, CFP®is Partner and Director of Investments at Center for Financial Planning, Inc. In 2011 and 2012, Melissa was honored by Financial Advisor magazine in the inaugural Research All Star List. In addition to her frequent contributions to Money Centered blogs, she writes frequent investment updates at The Center and is regularly quoted in national media publications including The Chicago Tribune, Investment News, and Morningstar Advisor.
Financial Advisor magazine's inaugural Research All Star List is based on job function of the person evaluated, fund selections and evaluation process used, study of rejected fund examples, and evaluation of challenges faced in the job and actions taken to overcome those challenges. Evaluations are independently conducted by Financial Advisor Magazine.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Center for Financial Planning, Inc., and not necessarily those of RJFS or Raymond James. Municipal bond interest is not subject to federal income tax but may be subject to AMT, state or local taxes. Income from municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment. Changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax and legal matters with the appropriate professional.