Benefit from a tax-savvy investment portfolio

Physicians of all specialties want to reduce taxes wherever possible. While most doctors typically focus on active professional income, spending some time and effort on how one’s investments are taxed is also crucial.

In fact, writing a large check to the Internal Revenue Service serves as a harsh reminder that tax planning, including how it relates to investments, requires and is not a technique you can properly manage only at tax time.

In this article, we will provide you with six suggestions that could save you thousands of dollars in investment taxes over the next several years.

Account registration matters. Many physicians are familiar with the term “asset allocation” as it relates to one’s portfolio. However, a common mistake made by many is failure to implement an asset location strategy.

Sanjeev Bhatia

David B. Mandell

Individually owned brokerage accounts, Roth IRAs and qualified plans are subject to various forms of taxation. It is important to utilize the tax advantages of these tools to ensure they work for you in the most productive manner possible.

As a few examples, investment vehicles paying qualified dividends are preferred in an individual or joint brokerage account, while it is generally preferable for qualified accounts to own high yield bonds and corporate debt taxed at ordinary income rates.

There are countless additional examples we could discuss, but the lesson is that it is important to review the pieces of your plan with an advisor who will consider both asset allocation and asset location as they relate to your specific circumstances.

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 doctors whose income puts them in the top income tax bracket.

Under these circumstances, a municipal bond yielding 3% will provide a superior after-tax return in comparison to a corporate bond yielding as high as 5% in an individual or joint registration, a pass-through LLC or in many trust accounts.

Be cognizant of holding periods. Long-term capital gains rates are much more favorable than short-term rates. Holding a security for a period of 12 months or longer presents an opportunity to save nearly 20% on the taxation of your appreciated position. For example, an initial investment of $50,000 that grows to $100,000 represents a $50,000 unrealized gain. If an investor in the highest tax bracket simply delays liquidation of the position (assuming the security price does not change), the tax savings in this scenario would be $8,500.

Although an awareness of the holding period of a security would appear to be a basic principle of investing, many mutual funds and managed accounts are not designed for tax sensitivity. High income investors like most physicians need to be cognizant of this fact. Therefore, it is generally advantageous to seek the advice of a financial professional who is aware of holding periods and has experience executing an appropriate exit strategy.

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, it 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.

Think twice about gifting cash. This is not to discourage your charitable intentions. Quite the opposite is true. However, a successful investor can occasionally find themselves in a precarious position. You may have allocated 5% of your portfolio to a growth stock with significant upside. Several years have passed, the security has experienced explosive growth and it now represents 15% of your investable assets. Suddenly your portfolio has a concentrated position with significant gains, and the level of risk is no longer consistent with your long-term objectives. The sound practice of rebalancing your portfolio then becomes very costly, because liquidation of the stock could create a taxable event that may negatively impact your net return.

By planning ahead, you 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 your gift can be replaced with the cash you originally intended to donate to the charitable organization, and, in this scenario, your cash will create a new cost basis. The charity has the ability to liquidate the stock without paying tax, and you have removed a future tax liability from your portfolio.

Implementing the aforementioned gifting strategy offers the potential to save thousands of dollars in taxes over the life of your portfolio.

Understand your mutual fund’s tax cost ratio. The technical detail behind a mutual fund’s tax cost ratio is beyond the scope of this article. Our intent is to simply bring this topic to your attention. Tax cost ratio represents 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. But all mutual funds are not created equally, and proper research will allow you to identify funds that are tax efficient.

A well-managed mutual fund will add diversification to a portfolio while creating the opportunity to outperform asset classes with inefficient markets. You do need to be aware of funds with excessive turnover. Moreover, an understanding of when a fund pays its capital gains distributions is critical. The bottom line: 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.

These steps are by no means the only tax strategies experienced advisors can execute on behalf of their clients. In today’s tax environment, physicians must choose an advisor who will help them look beyond portfolio earnings and focus on strategic after-tax asset growth.

Reference:

• The newly published, Wealth Planning for the Modern Physician: Residency to Retirement, is available free in print or ebook formats by texting HEALIO to 47177 or at www.ojmbookstore.com. Enter code HEALIO at checkout.

For more information:

Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon at Northwestern Medicine in Warrenville, Ill. He can be reached at: sanjeevbhatia1@gmail.com.

David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm, OJM Group, www.ojmgroup.com. You should seek professional tax and legal advice before implementing any strategy discussed herein. He can be reached at: mandell@ojmgroup.com or (877) 656-4362.