Mitigating Tax Consequences in the Investment Process Is Important
Author: Stephanie Hurt
Solid investment returns are important to financial success. However, it’s not just what an investor earns that matters. It’s also about the after-tax returns—what the investor gets to keep. BKD Wealth Advisors takes an active approach to improving after-tax results, including the following:
Asset Location – For investors with a combination of taxable, tax-deferred and tax-free accounts, opportunity exists to select which assets are purchased in the various account types. Buying the least tax-efficient assets in tax-deferred accounts and the most tax-efficient assets in taxable accounts can help improve after-tax returns. In tax-free accounts, investing in assets with the highest expected long-term returns often makes sense, since this growth isn’t expected to be subject to future taxation.
Security Selection – Selecting index funds and municipal bonds for taxable portfolios can also improve after-tax results. Index funds replicate a particular index without subjective decision making on the part of the manager. Because of this passive approach, index funds tend to have fewer purchases and sales since the constituents of any given index are fairly consistent over time. Fewer trades typically mean lower capital gains distributions compared to actively-managed funds, leading to greater deferral of taxes.
Tax-exempt municipal bonds generate income that is usually federally tax-exempt and sometimes state tax-exempt. Typically, tax-exempt bonds pay lower interest rates compared to taxable bonds of similar quality and maturity. However, after-tax returns often are still higher for taxpayers in the top tax brackets.
Tax-Loss Harvesting – Periods of market volatility can afford investors the opportunity to harvest losses from positions trading below their cost. When harvesting losses, the proceeds from selling the security are reinvested in a replacement position with equal or superior investment characteristics, or the proceeds are held in cash to be reinvested into the same security after 30 days pass. The realized losses then may be used to offset gains realized in the same year or carried forward to offset gains in future years.
Cost-Basis Accounting Method – Most custodians and brokerage firms offer several methods of applying cost basis to securities sales. Unless a conscious effort has been made to select the accounting method, the first-in, first-out (FIFO) method will often apply as the default. The FIFO accounting method applies the cost basis of the oldest lots of a security to a sale. This means the first tax lots of the security acquired will be sold first. Commonly, the oldest tax lots are those with the greatest embedded gain, making the FIFO method less than ideal from a tax management standpoint. Other cost-basis accounting methods are available that may be more effective in mitigating capital gain taxes.
Partner with a Tax Advisor – Consult with your tax advisor to discover additional methods of improving tax efficiency. These strategies may include the use of appreciated securities for charitable gifting, calculated individual retirement account (IRA) conversions, establishing a donor-advised fund and directly paying IRA management fees.
An active effort to manage the tax implications of your investment portfolio can increase after-tax returns and improve the odds of achieving financial success. If you have questions about these strategies or other tax-savings strategies, please contact your BKD Wealth Advisors professional or BKD tax advisor.