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Tax-Smart Investing

"Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the Treasury…Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands."

-Judge Learned Hand, 1934

Reducing investment-related taxes is one of the few sure ways to increase portfolio returns. Taxes affect investment returns in a complex manner. Your tax liability is influenced by the sequence of investment flows, the cost basis of equities in your portfolio, gains or losses in assets over time, and your investment horizon. Other contributing variables include dividend distributions, the timing of realized gains and losses, and your tax bracket. Your tax liability is also influenced by the final disposition of your assets. For example, you may receive a step-up in cost basis upon leaving assets to your heirs, which effectively eliminates the portfolio's tax liability.


Capital gains are taxed only when you sell a stock, not when the gains actually occur. Under the U.S. Tax Code, short-term realized capital gains are taxed as ordinary income, while long-term realized capital gains are subject to lower tax rates for individuals in mid and higher tax brackets. Securities held 12 months or longer are classified as long-term holdings, while assets held less than 12 months are considered short-term holdings.


Tax-Smart Strategies


Strategies for increasing after-tax returns include: 1) the HIFO (highest in, first out) accounting procedure; 2) offsetting realized capital gains with capital losses; 3) reducing dividend distributions; and 4) coordinated management of taxable and tax-deferred accounts.


HIFO Accounting


HIFO accounting is performed by recording the date, number of shares, and price per share each time a security is bought or sold. When selling a portion of a security holding, the shares purchased at the highest price are sold first. This minimizes the realized gain from a profitable sale and maximizes the realized loss from an unprofitable sale. HIFO accounting does not eliminate tax liability, but effectively defers a portion of the liability to a future date, thereby reducing its present value.


Offsetting Realized Capital Gains


Investment-related taxes can be minimized by offsetting realized capital gains with realized losses. In theory, you can eliminate capital gains taxes by realizing losses as they accrue and deferring capital gains indefinitely. Deferral of realized capital gains alone produces a tax advantage because it reduces the present value of the tax liability. For example, if we assume a discount rate of 8%, a capital gains tax rate of 15% is discounted to 10.2% in five years and 6.9% in 10 years. Some capital gains cannot be deferred indefinitely, however, due to cash flow needs or portfolio rebalancing requirements. These realized gains can be offset to a large extent by realizing capital losses as they occur. Transaction costs should not be ignored and therefore some guidelines are required regarding the realization of capital losses. A loss should not be taken, for example, until the tax savings from the loss exceed the transaction cost.


The wash-sale rule is a potential impediment to tax-smart investing. This rule prohibits realization of a capital loss for a security that is purchased within the preceding 30 days. The rule also disallows realization of a capital loss for a security that is sold at a loss and repurchased within 30 days. This problem can be mitigated by selecting a substitute security for repurchase with similar risk and return characteristics to the security sold at a loss. This allows appropriate portfolio weightings to be maintained, while offsetting realized capital gains with realized losses.


Liquidation of a long-held portfolio usually generates a substantial tax liability due to realization of embedded capital gains. When possible, you should delay portfolio liquidation until retirement, at which time you will typically enter a lower tax bracket. Further postponement of capital gains realization can be even more beneficial. Under present law, the deferred tax liability from embedded capital gains is forgiven at death. This powerful incentive for holding onto your assets has been referred to as "free life insurance from the IRS."


Reducing Dividend Distributions


Your tax liability can be further reduced by choosing stocks or funds with low dividend yields. The risk of tilting a portfolio toward low dividend stocks is that it could cause underweighting of certain sectors or industry groups, which in turn could lead to impaired performance.


Coordinated Portfolio Management


Most investors have both taxable and tax-deferred investment accounts. Tax-deferred accounts typically contain funds earmarked for retirement with specific penalties for early withdrawal of the funds. Savings that do not qualify for retirement accounts are invested in taxable accounts. Although taxable and tax-deferred accounts are often managed independently, it is in your best interest to coordinate the management of these accounts to achieve your investment goals. Here are just a few strategies for increasing your after-tax returns with coordinated portfolio management:


  • Strategic placement of government and corporate bonds in tax-deferred accounts and tax-exempt municipal bonds in taxable accounts.

  • Real estate investment trusts (REITs) are required by IRS guidelines to pay out 90% of their income each year in taxable dividends to their shareholders. REITs should therefore only be held in tax-deferred accounts.

  • Roth assets (Roth IRA, Roth 401k, Roth 403b): Unlike traditional tax-deferred assets, Roth assets are tax-free upon withdrawal during retirement. If you have a long investment time horizon, it therefore makes sense to be more aggressive with your Roth assets to achieve a higher expected rate of return and less aggressive with your traditional tax-deferred assets, that will be taxed as income upon withdrawal.

  • Foreign tax credit: Most international mutual funds and exchange-traded funds are required to pay foreign taxes. If held in a taxable account, you will receive a tax credit for these payments that you may be able to use to reduce your U.S. taxable income.

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