Year-end portfolio checklist: Proactive planning can reduce taxes on investments
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As we approach the year end, many investors, including physicians, will review their portfolios and assess the last 12 months of performance.
Typically, when an investment review occurs, the focus is on gross returns without any consideration of taxes. While many physicians think about taxes when writing a large check to the IRS, year-end planning opportunities can often be overlooked. This oversight is particularly common when it comes to investment tax mitigation. Proactive investment tax planning is most effective if it occurs throughout the year.
This article offers six strategies that could save you thousands of dollars in investment taxes over the next several years. The first two suggested action items are timely and, if implemented, could result in immediate tax savings for the current calendar year.
Strategic tax swaps
Proactively realize losses to offset gains. One benefit of holding a diversified portfolio is that, if structured properly, the securities typically will not move in tandem. This divergence of returns among asset classes not only reduces portfolio volatility, but also creates a tax planning opportunity. When some holdings within a portfolio have experienced gains while others have declined, an astute advisor can use this situation to save clients thousands of dollars in taxes by performing strategic tax swaps prior to year-end.
It is important to understand the rules relating to wash sales when executing such tactics. The laws are confusing, and if a mistake is made your loss could be disallowed. Make certain your advisor is well-versed in utilizing tax offsets.
Recent economic conditions have created a unique scenario where both stocks and bonds have sold off. Current tax law allows investors to realize losses to offset all realized gains in the current year, while additional losses can offset up to $3,000 in income. Losses exceeding $3,000 can be used to offset capital gains in future years.
Charitable donations, gifting cash
Charitable donations can reduce your tax bill; however, gifting cash may not be the optimal solution. We are not discouraging charitable intentions, but we do encourage leveraging current laws to maximize your tax savings. Gifting appreciated stock is a superior alternative to gifting cash in most cases.
Consider the following example to help illustrate the benefit of gifting appreciated stock. Doctor Dave has allocated 5% of his portfolio to a growth stock with significant upside. Several years have passed, the security has experienced explosive growth, and the stock now represents 15% of portfolio assets. Suddenly Dave has a concentrated position with significant gains, and the level of risk is no longer consistent with his long-term objectives. The sound practice of rebalancing the portfolio then becomes very costly because liquidation of the stock could create a taxable event that may negatively impact net returns.
By planning ahead, Dave may be able to gift a portion of the appreciated security to a charitable organization able to accept this type of donation. The value of his gift can be replaced with the cash he originally intended to donate to the charitable organization; and, in this scenario, the cash will create a new cost basis. The charity can liquidate the stock without paying tax, and Dave has removed a future tax liability from his portfolio. Implementing the gifting strategy offers the potential to save thousands of dollars in taxes over the life of a portfolio.
Accelerate gifting
Accelerate gifting in high tax years. Did you sell your interest in a practice or surgery center? Were you the recipient of an unusually large bonus? Did you experience a large capital gain from selling an appreciated stock or from the liquidity event of a private investment? You may be a candidate for a Donor Advised Fund (DAF) — an investment account designed to support charitable organizations.
One of the appealing benefits of a DAF is that you can receive a tax deduction for your contribution prior to sending the donation to the organizations. An investor could pre-fund a 5- or 10-year gifting program and receive the entire deduction in the year the DAF is funded. Donors are not required to designate the final recipient prior to funding the DAF, providing the opportunity to be deliberate in assessing the organizations or charities that are most meaningful to the donor.
Rules can be complex and the differences in the DAFs offered by custodians can be drastic. We would recommend working with your team of advisors prior to implementing the strategy described.
Municipal bonds
Consider owning municipal bonds in taxable accounts. Most municipal bonds are exempt from federal taxation. Certain issues may also be exempt from state and local taxes. This may be attractive to many physicians whose incomes put them in the top income tax bracket. Under these circumstances, a municipal bond yielding 4% will provide a superior after-tax return in comparison with a corporate bond yielding 6.5% in an individual or joint registration, a pass-through LLC, or in many trust accounts.
Asset location strategy
Implement an asset location strategy. Many are familiar with the term “asset allocation” as it relates to one’s portfolio. However, a common mistake made by many investors is failure to implement an asset location strategy. There are two components to successfully implementing this strategy. The first step is understanding how various account registrations are taxed. Step two is a recognition of how the underlying investment products and their respective income are taxed.
Individually owned brokerage accounts, Roth IRAs and qualified plans are subject to various forms of taxation. It is important to use the tax advantages of these tools to ensure they work for you in the most productive manner possible. It may be useful to share a few examples of aligning products and account registration for tax optimization.
Investment vehicles paying qualified dividends are subject to a lower tax rate and, therefore, are preferred in an individual or joint brokerage account. High-yield bonds and corporate debt taxed at higher ordinary income rates are typically recommended for qualified accounts. Growth stocks, which may not distribute any income, can be a great wealth accumulation tool in nonretirement accounts that tax income annually.
Tax-cost ratio
Understand your mutual fund or ETFs tax-cost ratio. The technical detail behind a fund’s tax-cost ratio is beyond the scope of this article. Our intent is simply to bring the topic to your attention. Tax-cost ratio is the percentage of an investor’s assets that are lost to taxes. Mutual funds avoid double taxation, provided they pay at least 90% of net investment income and realized capital gains to shareholders at the end of the calendar year. All funds are not created equally, and proper research will allow you to identify funds that are tax efficient. A high tax-cost ratio means the fund is less tax-efficient and should typically be owned in a retirement account.
Funds with excessive turnover tend to have a high tax-cost ratio. Understanding the tax-cost ratios of the funds that make up portions of your investment plan will enable you to take advantage of the many benefits of owning mutual funds. Investors can utilize tax-cost ratio to help with their asset location decisions.
Conclusion
Attention to investment tax adds to your bottom line. Implementation of one of these tactics alone, in any given year, may modestly reduce a physician’s tax bill. However, in combination and over time, they can significantly reduce taxes and increase net investment returns. Physicians should choose an advisor who will help them look beyond portfolio earnings and focus on strategic after-tax asset growth.
For more information:
Wealth Planning for the Modern Physician and Wealth Management Made Simple are available free in print or by ebook download by texting HEALIO to 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group www.ojmgroup.com, where Andrew Taylor is a partner and wealth advisor. You should seek professional tax and legal advice before implementing any strategy discussed herein. Mandell and Taylor can be reached at mandell@ojmgroup.com or 877-656-4362.
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