An intelligent investor is an informed investor
From the Desk of Jeff DeLarme
Timely insights from Jeff DeLarme, CFP®
Wealth Briefing: January 2021
IT’S NOT WHAT YOU MAKE, IT’S WHAT YOU KEEP
Investors may be able to enhance their net investment results by implementing tax-sensitive strategies within their portfolio. When constructing an investment portfolio, investors need to think not just about the return they achieve, but the return they earn net of taxes. Put simply; it’s not what you make, it’s what you keep. The following are a few ways that investors may seek to reduce the tax implications within a taxable portfolio.
WHY CONSIDER TAX-SENSITIVE STRATEGIES?
From time to time, we’re asked if tax-sensitive investing is really worth the effort. After all, it seems logical that if you’re paying taxes, you’re probably doing something right. To this we submit that if you can achieve the same pre-tax return on an investment, but in one scenario you pay 35% tax and another you pay 20%, wouldn’t that difference be meaningful? In other words, it’s not what you make – it’s what you keep.
AVOID SHORT-TERM CAPITAL GAINS
Since long-term capital gains (gains on investments held more than one year) enjoy lower tax rates as compared to short-term capital gains (gains on investments held less than a year), investors may be wise to avoid generating short-term gains where possible. In practice, investors may wish to defer the sale of a profitable investment until they’ve held it for at least one full year. This may seem obvious, but it’s often the case that we’ll see someone sell an investment and pay short-term gains when, if they just waited two or three days, they would have paid at the lower long-term rates.
TRADE LESS FREQUENTLY
Of course, another way to reduce capital gains is to simply trade less frequently. Investors need to balance the pros and cons of managing their portfolio to their stated objectives – which is paramount in our view – but as an important secondary consideration, they should avoid unnecessary trading in taxable accounts. When evaluating mutual funds for taxable accounts, we tend to favor funds that trade less frequently and thus exhibit lower turnover ratios. As an aside, most all funds incur costs when they trade, and so fewer trades should result in lower trading costs, effectively allowing an investor to keep more of their returns.
THINK TWICE ABOUT (HIGHLY) ACTIVE MUTUAL FUNDS
Investors may be in for an unpleasant surprise when they learn that a mutual fund they’ve only held for 3 months and that is trading at a loss, is now distributing a sizeable, taxable capital gain. In a mutual fund investment, investors share in the gains and losses of the fund at the time the gain or loss is realized, regardless of how long they’ve personally owned the fund. For some managed funds, the managers may decide – or in some cases, be forced – to sell a position that was held for years or even decades. When that position is sold at a gain, the current investors are on the hook for the gain despite perhaps having only been invested in the fund for a brief period of time. The good news is that most mutual fund managers share their estimated gains prior to distributing them and so a diligent investor may be able to take action before they’re on the hook for a taxable event.
PROACTIVELY SEEK OPPORTUNITIES TO HARVEST TAX LOSSES
During a given year, if an investment in a taxable account is showing an unrealized loss, investors may be wise to sell or exchange out of the fund into a similar strategy for at least 31 days. This process, known as tax loss harvesting, allows investors to realize a loss to offset future gains. In executing this strategy, investors must be careful to choose a similar but not identical strategy to reinvest in. Importantly, they must also be sure to remain out of the exited position for at least 31 days or risk running afoul of IRS wash sale rules.
RETHINK DIVIDEND-FOCUSED INVESTMENT STRATEGIES
Many investments are designed and marketed to generate high levels of dividends. While this strategy has its place for some investors and account types, generally speaking and from a tax perspective, we would prefer the funds that pay fewer dividends. The rationale here is that while some dividends are taxed at lower rates, they’re still taxed. As compared to investments that do not generate high levels of dividends, these dividend-strategies may yield less after-tax. But what is an income-seeking investor to do if their portfolio dividends are lower than the level of cash flow required? Create your own by selling or rebalancing part of your portfolio when it makes sense for your income needs.
THOUGHTFUL ASSET LOCATION
Investors often spend too much time thinking about their asset allocation (the mix of stocks to bonds to cash, etc.) and almost no time on their asset location. By design, certain investments are more tax-advantaged than others. For example, municipal bonds, while they might be subject to the alternative minimum tax, may be both federally and state tax exempt. These types of investments usually make the most sense in taxable accounts as compared to retirement accounts where investors already enjoy tax-deferral or tax-free treatment. Comparatively, corporate bonds typically pay interest that is taxed at ordinary income tax rates. For further comparison, many stock investments pay dividends that are taxed at lower, long-term capital gains rates, and thus may achieve better tax treatment in a taxable account than the aforementioned corporate bonds. A few words of caution: many pundits have advised, based on this logic, that you hold stocks in taxable accounts, and bonds in retirement accounts, purely based on the tax treatment. However, we submit that each account should be optimized based on the time horizon of those specific funds. Meaning, if your retirement account won’t be touched for 20 years, it probably doesn’t make sense to own mostly bonds in that account. Similarly, if your taxable account is a short-term account that you’ll pull funds from within 5 years, owning mostly stocks can be hazardous.
ARE TAXES THE MOST IMPORTANT CONSIDERATION?
We’ve spent the above paragraphs talking about the importance of tax-strategy in the context of investing, but it’s worth noting that while important, taxes shouldn’t be the sole factor in evaluating an investment’s merit. As the old phrase goes, let’s not let the tax tail wag the investment dog.
Paying tax is clearly part of our civic duty, but some investors also question whether or not it’s morally wrong to invest in a manner that seeks to limit their tax liability. To this we respond that we should of course pay our fair share as provided by the tax code, but let’s seek to avoid paying more than our fair share. The challenge is in determining what that amount is, and this is likely why so many of us engage tax professionals each year. And last we checked, the IRS doesn’t tell you what strategies you could have employed (but didn’t) to legally pay your fair share.
We spend countless hours every year consulting with our network of CPA and tax professionals on behalf of clients and find the value of tax professionals to be immeasurable. As a result, we highly encourage you to work with a quality tax professional. We would be delighted to introduce you to someone we believe could be an ideal fit for your situation.
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. Any opinions are those of DeLarme Wealth Management, and is not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected individual investor’s results will vary. Raymond James nor DeLarme Wealth Management, Inc. provide tax or legal advice. Dividends are not guaranteed and must be authorized by the company’s board of directors.
Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC. Investment advisory services offered through Raymond James Financial Services Advisors, Inc. DeLarme Wealth Management is not a registered broker/dealer, and is independent of Raymond James Financial Services.
Investors should carefully consider the investment objectives, risks, charges and expenses of mutual funds before investing. The prospectus and summary prospectus contains this and other information about mutual funds. The prospectus and summary prospectus is available from your financial advisor and should be read carefully before investing.
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