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How Tax-Efficient Is Your Portfolio?

Man wonders how tax-efficient his portfolio is

5 Key Questions to Determine Your Portfolio’s Tax Efficiency

When planning for your financial future, the amount you pay in taxes can have a big impact on your ability to achieve your goals. The process of filing your annual taxes can highlight many of your income tax liabilities, but have you considered the tax efficiency of your investment portfolio?

If you’re not actively managing your investments’ tax exposure, you could be missing out on significant growth opportunities. Following are five key questions to help you determine the tax efficiency of your portfolio.

#1 – Are you harvesting losses to offset gains?

Within a taxable investment portfolio, you’re only taxed on net capital gains, which equals gains minus losses. This means any realized losses in a given year can be subtracted from capital gains in order to reduce your tax liability.

The process of selling an investment that’s declined in value in the short term and replacing it with a highly correlated alternative is called tax-loss harvesting. If done correctly, the risk profile and expected return of your portfolio remain unchanged, but up to $3,000 per year in investment losses can be used to offset gains elsewhere in your portfolio. If you realize more than $3,000 in losses in a single year, you can carry over the excess amount to offset capital gains in future years.

By realizing an investment loss within your portfolio, you can access a tax deduction then reinvest your tax savings to further grow the value of your portfolio.

Important note – The “wash sale” rule

When implementing a tax-loss harvesting strategy, it’s important to understand the IRS’ wash sale rule. This rule is intended to prevent investors from selling an investment at a loss for the sole purpose of obtaining a tax deduction while continuing to maintain the same investment allocation.

A wash sale can be triggered if you sell an investment at a loss and, within 30 days, buy back a “substantially identical” security — or when you sell an investment at a loss in a taxable account then buy it back in a tax-advantaged account. In addition, a wash sale can be triggered if your spouse or a company you control buys a substantially identical security during the 30 days before or following your sale.

If you trigger a wash sale, you’ll be unable to claim a tax loss, which is why it’s wise to work with a qualified wealth manager to help ensure your tax-loss harvesting strategy maintains an appropriate allocation without triggering a wash sale.

#2 – Are you taking full advantage of tax-efficient accounts and investments?

Asset location is a strategy that can help lower your investments’ tax exposure and enhance returns by dividing assets among taxable and tax-advantaged accounts according to each asset’s tax characteristics. Using an asset location strategy, you’d allocate tax-efficient investments to taxable accounts and tax-inefficient investments to tax-advantaged accounts.

As stocks receive favorable capital gains tax treatment (tax rates much lower than ordinary income tax rates), it’s wise to place these investments in taxable accounts or Roth IRAs. Additionally, if these assets are passed on to heirs, they may be eligible for a “step-up” in basis, effectively resulting in zero taxation. Investments with lower return potential and unfavorable ordinary income tax treatment (such as U.S. government bonds and cash) should be placed in tax-advantaged accounts (like IRAs) to reduce their current tax exposure.

#3 – Do you have a tax-efficient withdrawal strategy in place?

Just as it’s important to contribute to accounts in a tax-efficient manner, it’s also important to develop a tax-efficient withdrawal strategy. The good news is if you’ve already implemented the asset location strategy noted above, you’re likely invested in a variety of accounts with different tax treatments, which gives you added flexibility as you consider your tax-efficient retirement withdrawal strategy.

There are two main tax-efficient withdrawal strategies to consider. The one that’s right for you depends on your overall tax situation and retirement income needs.

  • Traditional approach – Using this approach, you withdraw from one account at a time, typically beginning with taxable accounts first, followed by tax-deferred accounts and, finally, tax-exempt accounts. This approach allows the tax-advantaged accounts to continue growing tax-deferred for a longer period of time. The challenge, however, is that you’ll likely have more taxable income in some years than in others.
  • Proportional approach – With this withdrawal strategy, you establish a target percentage to withdraw from each account each year. The amount is typically based on the proportion of retirement savings in each account type. This approach can potentially provide a more stable tax bill from year to year and help you save on taxes over the course of your retirement.

#4 – Are you considering tax-efficient alternatives to mutual funds?

Mutual funds can play a role in a diversified portfolio, but they’re not always the most tax-efficient option. Because of how they’re designed, mutual funds must sell securities in order to accommodate redemptions and rebalances. This practice can result in multiple taxable events for shareholders. In addition, mutual funds regularly pay dividends to shareholders in the form of capital gains distributions. The IRS considers these distributions taxable income.

As an alternative, it may make sense to consider investing in exchange-traded funds (ETFs). ETFs’ structure allows them to operate in a more tax-efficient manner. Instead of selling securities to accommodate redemptions and rebalances, ETFs can typically swap shares in kind at a low cost basis, resulting in lower taxable gains.

#5 – Are you making tax-efficient charitable donations?

Of course, the primary benefit of making charitable donations is supporting causes doing good work in your community and around the world. A secondary benefit of contributing to charity is lower tax exposure. Giving cash is a great way to support the causes that matter to you, but there can be additional tax benefits for both you and the charitable organization if you consider other ways to donate.

Following are two examples of tax-efficient giving strategies:

  • Appreciated securities – Making an in-kind donation of appreciated securities, such as stocks, bonds or mutual funds, can offer tax advantages to both you and the charitable organization.

    For example, let’s say you wish to donate $10,000 to your favorite charity. You decide to sell stock from your investment portfolio to fund the donation. Your cost basis on the $10,000 of stock is $2,000, and you fall into the 20% capital gains tax rate. If you sell the stock for $10,000 and donate the proceeds, you’d owe capital gains taxes on $8,000 (the stock’s current market value minus its cost basis). At a 20% capital gains rate, you’d need to pay $1,600 in taxes. Subtracting $1,600 from $10,000 leaves $8,400 to donate to the charity. You’d then be able to deduct $8,400 in charitable donations from your itemized tax return.

    If, instead, you decide to make an in-kind transfer of the appreciated stock directly to the charity, you could avoid triggering a taxable event, and the charity could receive the full $10,000 value of the stock. Because charitable organizations are tax-exempt, the charity could then sell the stock without paying taxes on the transaction. As a result, you could claim a $10,000 charitable deduction on your itemized tax return, and the charity would receive the full market value of the stock. That’s a win-win situation for both you and the cause you wish to support.

  • Donor-advised funds (DAFs) – Another great way to lower your tax exposure while maximizing your charitable impact is by establishing a DAF, which is a 501c3 charitable fund that holds irrevocable charitable gifts. As the donor, you retain control over the timing of charitable donations as well as the organizations to which donations are made.

    One of the main benefits of establishing a DAF is that you can make a single large donation of cash, stocks or other assets during a year in which your income is higher than normal, then you can distribute assets to charities over several years. This practice allows you to claim a charitable deduction on your itemized tax return in the year you make the donation while supporting charities over several years. This strategy often makes sense for soon-to-be retirees, who use it as a tax-savings opportunity during their working years so that they can support various charities throughout retirement.

    Another benefit of this strategy is that the assets within the DAF can be invested and grow tax-exempt over time within the account. This benefit provides you with an opportunity to establish a charitable legacy for future generations of family members, as your children and grandchildren can have a say in how assets are donated to various organizations.

Could you use some help improving the tax efficiency of your investment portfolio? Creative Planning is here for you. Our experienced investment professionals work with you to develop a custom investment portfolio specifically designed to help lower your tax exposure, optimize your returns and support your long-term investment goals. For more information, schedule a call with a member of our team.

This commentary is provided for general information purposes only, should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.

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