Paying Too Much in Taxes? Two Ways to Manage Taxes in Your Portfolio

As Benjamin Franklin said, there are only two things certain in life—death and taxes. While both may be inevitable, the amount of taxes you pay can still be in your control, especially when it comes to your investment strategy. In part four of our five-part series on identifying common portfolio mistakes and resolving them, we’ll delve into the tax efficiency of your portfolio and how to make your investments work for you.

There are techniques that, when employed properly, will help you increase your take of your portfolio’s investment return by better managing the taxable portions of your portfolio. The following two methods are amongst the most popular and impactful.

Asset Location

Many are familiar with the concept of asset allocation, the process of dividing your portfolio amongst different strategies to provide diversification. A distant cousin of this strategy is asset location, which involves further dividing the portfolio to achieve tax efficiency.

In a well-designed asset location strategy, investments that are likely to create higher amounts of current taxable income (i.e. dividends, interest, short-term capital gains) might be considered for allocation into accounts that shield those earnings from taxes, such as traditional IRAs. Alternatively, investments that generate low amounts of taxable income or short-term gains would be best held in taxable accounts. Below is a general guideline to help decide which investment types fall into which category:

Investment Type Tax Categories
Source: Fidelity

Is Asset Location Right for You?

In the world of investments, there is no one-size-fits-all solution. As such, an Asset Location strategy cannot be universally applied to every portfolio. Items to take into consideration before attempting to construct an asset location strategy include:

  • Whether you have to have the proper mix of accounts. For an Asset Allocation strategy to be effective, you need the correct account types and the proper amount of assets within those account types.
  • Whether you are in a higher marginal income tax bracket. The larger the spread between your ordinary income tax rate and your long-term capital gain rate, the more effective this strategy becomes.
  • Whether you expect your tax rate (federal and/or state) will be lower when you retire and start to withdraw from your IRA.
  • Whether you own, or intend to own, investments that will result in higher taxes today if owned in a taxable account.

Tax Loss Harvesting

Another technique to improve your tax efficiency is tax loss harvesting. Tax loss harvesting is the process of selling a security at a loss to harvest the tax benefit that loss can provide. The proceeds from the sale are reinvested in a similar but not identical replacement security to keep market exposure constant. That harvested loss has an economic benefit, as it can be used to offset future gains which would have otherwise been taxed. Further, because the proceeds from the sale were reinvested to maintain market exposure, the portfolio continues to participate in the market.

After 30 days have passed, if you want to repurchase the security you sold at a loss, you can sell the replacement security and repurchase the security you sold at a loss. The higher your tax bracket, the more beneficial this strategy can be. For example, an investor who pays a 15% capital gain tax would effectively save $0.15 of tax for every dollar of future gain.

Despite the benefits, investors are often reluctant to employ a harvesting strategy. They have been preconditioned that you haven’t truly lost money on an investment until you sell the investment and lock in that loss. By its very nature, a harvesting strategy is locking in the loss. That is why reinvesting the proceeds from the sale in a highly correlated, but not identical security, is so important. It allows the investor to continue to participate in the market while they stay out of the sold security for the required 30-day period (see Wash Sale Rule below).

Is Tax Loss Harvesting Right for You?

As in asset location, there are certain conditions to consider before employing a harvesting strategy.

Beware of the Wash Sale Rule. The IRS does not allow you to sell an asset solely for the purpose of paying less tax. For example, you couldn’t sell IBM on a Monday to recognize the loss and buy IBM on Tuesday. The IRS indicates that the loss will be disallowed if the same or substantially identical security is purchased within 30 days from the date of the sale. If you’re trying to engage a tax harvesting strategy, don’t get tripped up by the substantially identical classification. While there are no hard a fast rules we know of, selling the Vanguard 500 Index Fund and replacing it with an S&P 500 Index ETF would likely raise a red flag.

There could be an opportunity cost. Because the replacement security cannot be identical, its performance will differ from the security you sold. If it underperforms over the 30-day period, that will diminish the effectiveness of the strategy. In tax harvesting, this is a risk that you assume; therefore, you should make sure the tax benefit is sizeable enough to warrant the risk. Taking a $1,000 loss, resulting in a $150 potential tax savings, on a $100,000 investment doesn’t make a lot of sense, as a slight differential in the return between the two investments could wipe out any benefit. However, the larger the loss as a percentage of the security value, the more effective the strategy is likely to be.

Be careful in selecting the replacement security. As we mentioned above, your portfolio cannot be so similar that it violates the Wash Sale Rule. However, it shouldn’t be so dissimilar that it performs substantially different than the security it replaced. In other words, replace an apple with another type of apple, not an orange.

Depending on your unique situation, building a tax strategy around your investments could increase your portfolio’s efficiency. From asset location that takes the types of investments you own into account, to tax loss harvesting to maximize benefits, there’s bound to be a prudent strategy that could work for you. Our private wealth advisors have extensive expertise in crafting multi-dimensional approaches to tax efficiency, so don’t hesitate to contact us directly if you have any questions about your portfolio’s performance.

For more information on identifying common mistakes investors make in their portfolios, and how to address them, be sure to read through the first three installments of our five-part series and be on the lookout for the final chapter to be published soon.

Disclaimer: This is for informational purposes only and does not constitute investment or tax advice.

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