Death and Taxes: Focus on What You Can Control (Part II)

By Sam Martin, MBA (tax), CFP, CPA

This article is Part II of ‘Focus On What You Can Control.’ Read about Part I in Catalyst Q2 2015 HERE.


1. Income Tax Location: If you have both taxable accounts and tax-deferred accounts, you have an opportunity to increase your after-tax return by simply determining where various asset classes should be located. By utilizing the tax-deferred or tax-free accounts to place tax-inefficient assets, you avoid paying ongoing income and healthcare taxes. Inefficient assets classes include fixed income (bonds, bond funds, CDs, etc.), real estate (REITs), and commodities. These all pay out ordinary income that would be taxed at your marginal income tax bracket if held in your taxable account. Further, couples making more than $250,000 and single filers making more than $200,000 are subject to an additional 3.8 percent Medicare tax on investment income under the Affordable Care Act.

You might say, “But I could put tax-free municipal bonds in my taxable accounts, and they would not be subject to income or the 3.8 percent Medicare tax.” True, but tax-free municipal bonds pay significantly less than their taxable equivalents. In fact, on average, tax-free municipal bonds trail their taxable counterparts by 30 percent or more.

Consequently, individuals should only own tax-free municipal bonds if they are very high-bracket taxpayers and if there are insufficient funds to hold all of your bonds in tax-deferred accounts.

Locate tax-efficient asset classes to your taxable account. Generally, this will consist of equity (stock) asset classes. However, not all funds or strategies are created equally. Actively managed funds which buy and sell frequently in order to attempt to pick mispriced stocks and/or to time the market are extremely tax-inefficient, as well as more costly due to the frequency of trading.

Alternatively, if you have taken the time to study evidence-based investing and the preponderance of peer-reviewed research (which includes Nobel Prize-winning foundational principles), you know that it’s not necessary nor in your best interest to invest in actively managed funds or individual securities. Rather, you will use index or asset class funds that are very low cost and tend to have very low turnover (i.e., very little buying and selling and therefore very low taxable income).

To further increase portfolio tax efficiency you can utilize tax-managed funds where available. The manager of a tax-managed fund goes to great lengths to avoid taxes–especially the short-term gains that are taxed at your highest marginal tax bracket (plus 3.8 percent Medicare tax if applicable).

Oh, and asset location is important for estate planning also. The federal (and perhaps your state) government looks at $5,000,000 in your IRA or your taxable account in the same way for estate tax purposes. However, if you hold the appreciating assets in your IRA, your heirs will end up paying ordinary income tax on that appreciation. If the appreciating assets (at least those that are income-tax efficient) are held in your taxable account, your heirs receive a “step-up” in income tax basis and pay no tax on the applicable appreciation.

2. Tax Loss Harvesting: The vast majority of Wall Street firms and mutual funds ignore income taxes on individual investors. Why? Too much trouble. Some advisors will take a peek at your portfolio in November or December and perhaps recommend selling a loss position or two to offset gains taken earlier in the year. In our case, we believe that Tax Loss Harvesting is a 365 days per year activity.

Tax Loss Harvesting is the process by which you purposely sell a loss position in your taxable account in order to make the loss deductible, regardless of whether you have capital gains to offset. A capital loss first offsets any capital gains and then you can deduct up to $3,000 per year against ordinary income. Let’s say a dentist in the 33 percent tax bracket takes a $10,000 capital loss in her taxable account and that dentist had taken a $4,000 capital gain earlier in the year. The $10,000 loss will first offset the $4,000 gain leaving a $6,000 loss. That offsets taxable income to the tune of $3,000 for an income tax savings of $990 and a Medicare tax savings of $114. The excess is carried over to the following year where it will first offset any gains and otherwise be deducted in the same fashion against ordinary income resulting in similar savings.

Federal income tax law includes the “Wash Sale Rule.” This rule disallows the loss on the sale of a fund or security if you purchase the same asset within 30 days before or after the sale. This rule might give you pause if you felt being out of the market for 30 days might be more risky than the value of taking the loss. However, the law only forbids purchasing a “substantially identical” security or fund. Consequently, you simply replace the loss position with another fund that represents the same asset class. This way you do not have to be out of the market at all and your portfolio allocation is maintained–yet you still obtain the benefit of the loss.

Beyond the current savings a tax loss may provide, banking long-term capital losses can be very valuable. For example, let’s say we implemented a portfolio a few months ago including a $100,000 investment in the Large US Value Fund. Today, we find that the value of that fund has dropped to $90,000. We have a paper loss of $10,000. What is our expectation if we do not harvest the loss? The expectation is that over time the fund will appreciate not only back to its $100,000 but also well beyond. If we take the loss when it is $10,000 and replace the fund with a similar fund our expectation is exactly the same; however, we obtain the tax loss and related savings.

Eventually, you will have capital gains that you will need to take. If you own a practice or rental property you will eventually sell such assets, and having banked capital loss carry-over will reduce the tax owed at sale. Even if you do not have such assets you will eventually liquidate small portions of your appreciated investments to create cash flow during retirement. It is very nice to have a bank of losses to offset such gains.

3. There are a number of other tax management techniques, including avoidance of short-term gains, utilizing specific lot identification when selling a portion of a position, utilizing tax-managed funds where available, being sensitive to mutual fund distribution dates, and maximizing the advantages when charitable giving opportunities are desired—among others.

Even if you have only or mostly tax-deferred investments there is still substantial tax planning to consider: Roth conversions, indirect Roth contributions, and ultimately how to best manage the taxable income you will incur in your withdrawals phase. We will devote a future article to planning during retirement—but investment tax planning before and during the withdrawal phase remain equally important.

Face it: taxes bite. Anything you can reasonably do to reduce taxes (that is otherwise in your best interest) and/or optimize after-tax returns is a good thing and something over which you have a certain amount of control. Keeping unnecessary taxes out of the hands of the government, along with a strong cup of French Roast, is what gets me out of bed in the morning.

Click here to see the original article.

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