4 ways to keep clients’ portfolios from getting taxed to death
Your clients will appreciate it if you help them avoid the 43.4% tax bracket
The 2014 tax season just passed, but there are still plenty of ideas that can serve you and your clients well throughout the year. It’s not always easy, but working toward higher after-tax returns is worth it for tax-sensitive investors. Here are four tips to help you:
1. Control holding periods.
It would be easier if one could buy and hold forever, but your clients eventually will have to sell at least some of their securities.
We talk a lot about the importance of having a long-term perspective and this is especially relevant when considering the holding period of a security. When it comes to a tax-managed approach, the difference between a long-term and a short-term capital gain is huge.
Today, for example, long-term capital gains are taxed at 23.8% at the marginal federal tax level. But short-term capital gains are taxed at a whopping 43.4%. That’s a significant difference. However, this is one outcome that is easily within your control.
How the law defines a long-term versus a short-term holding period is 366 days or more and 365 days or less, respectively. So one day can make a really big difference in the potential tax liability your client may experience.
(Related read: Advisers ramp up efforts to ease tax bite on retirement income)
2. Avoid wash sales.
Selling a security at a loss and then buying it or a substantially similar security in 30 days or less generates a wash sale, which may either defer or sacrifice a loss in the client’s portfolio.
It’s relatively easy to avoid a wash sale. You just have to wait 31 days or longer to buy back that same, or a substantially similar, security you sold at a loss. Holding onto that loss is important because losses can be used as an effective tool to offset potential gains in a taxable portfolio.
3. Harvest losses when appropriate.
It would be easier if you had only gains to manage, but markets move.
Losses can represent an important lever in a taxable portfolio. Harvesting those losses can be a very effective strategy that can allow a manager or adviser to essentially use market volatility to their advantage.
While the market and individual securities are moving up and down, there are often potential opportunities for managing — and potentially minimizing — the tax liability in a portfolio.
It all comes down to managing the data of your client’s holdings, tax lots and trades to control the exposures in a portfolio.
When done well, harvesting losses can lead to a better after-tax outcome for your clients.
4. Lean toward nontaxable interest.
It would be easier if all investment income were tax free, but that’s not the case.
Investment income can often play an important role in the total return of a portfolio. But in a taxable portfolio, it pays to be aware of the tax implications associated with that income.
Income is typically generated by interest and dividends. On the fixed-income side, bonds pay interest that in most cases is taxed as ordinary income. Now if a client is in the highest federal income tax bracket, that equates to 43.4%. That’s a lot of potential return to give up to taxes.
But many municipal bonds have a 0% tax rate, which means the income they generate is nontaxable. So this becomes an important consideration — especially for high earners.
On the equity side, there are two kinds of dividends. For appropriate investors, you may want to consider focusing on qualified dividends because they’re the more attractive tax option in a tax-aware portfolio.
Qualified dividends are taxed at 23.8%. That’s far more attractive than 43.4% and that’s why each different source of income needs to be considered carefully.
We believe nontaxable interest and qualified dividends offer investors a more tax-efficient way to generate income for a taxable portfolio.
When you keep these kinds of ideas in mind, your clients stand a good chance of achieving a better after-tax return. And that’s really what it’s all about.
Rob Kuharic is an investment strategist for tax-managed solutions at Russell Investments.
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