United States

Improving tax efficiency of investment portfolios


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When thinking about tax efficiency, it is important to remember that while taxes are an important part of an investment plan and strategy, they are certainly not the only factor that needs to be considered. In addition, it is important for your wealth management advisor and tax professional to collaborate in understanding your unique needs, as there is no singular solution that fits all investors. Providing for greater investor tax efficiency is an active, dynamic, ongoing and client-specific process.

Viewing your investment plan from a total portfolio perspective
To create a tax-efficient investment portfolio, it is important to consider the overall plan and investment portfolio, rather than each individual investment. One major component of maximizing after-tax returns in your investment plan is referred to as asset location. Asset location refers to the type of account (taxable, tax-deferred or tax-free) in which an investor should purchase and hold various types of investments. Asset location strategies can vary based on investor-specific factors, such as investment timeline, liquidity needs and tax situation. In its simplest form, asset location recommends investors place their most tax-inefficient investments in their tax-deferred accounts whenever possible. This is often not a simple practice and needs to be reviewed for each individual situation.

Steps an advisor can take to improve the level of tax efficiency for the taxable investor
There are several steps advisors can take throughout the year to improve tax efficiency for a taxable investor.

  • Tax loss harvesting opportunities: This is a process where an investor sells a security that has fallen below its purchase price, or cost basis, realizing a tax loss. This loss can then be utilized to offset realized gains. A replacement security is purchased in place of the investment being sold in order to maintain the appropriate asset allocation. When tax loss harvesting, there are a few items to think about. First, investors should be careful to avoid the wash sale, which is an IRS rule that prohibits a taxpayer from claiming a loss on a sale of a security when a "substantially identical" security is purchased within 30 days before or after the sale. If a wash sale does occur, the loss is added to the basis (purchase price) of the new shares. Second, be sure to look for tax loss harvesting opportunities throughout the year and not just at year-end.
  • Paying attention to tax lots when selling securities: Trading systems have different accounting methodology capabilities. For example, with tax lot accounting, there are three main options: highest in, first out (HIFO), first in, first out (FIFO) and last in, first out (LIFO). At RSM US Wealth Management, we prefer the HIFO methodology for taxable investors, as it will generally reduce the tax impact of a sale and can therefore help to improve after-tax returns.
  • Avoiding short-term gains: Capital gains from the sale of a security are taxed at ordinary income rates unless the security is held for a period longer than 12 months, when it may qualify for a lower tax rate. At RSM US Wealth Management, we pay attention to holding periods in order to limit the amount of short-term gains generated for taxable investors.
  • Defer the realization of gains: The U.S. government taxes investment gains only when an asset is sold; thus, the tax liability is deferred as long as the security is held. All else being equal, the longer the realization of gains can be deferred, the better.
  • Avoiding mutual fund purchases before ex-dividend dates: Mutual funds are required to distribute their income to shareholders, resulting in a taxable event. The ex-dividend date is the date when the fund net asset value (NAV) is lowered by the amount of the dividend. Whether investors have held the mutual fund for one day or a thousand days, each investor who is a registered owner of the fund on record date receives the same pro rata distribution. Therefore, investors should know when the ex-dividend and record dates are and work to avoid any unnecessary taxable distributions. Similarly, if investors are looking to sell a particular mutual fund, it could be advantageous to sell the mutual fund just before the ex-dividend date as opposed to just after it. While mutual funds were used as the investment vehicle referred to in this example, mutual funds and exchange-traded funds (ETFs) have varying timing for when record dates and ex-dividend dates occur, so it is important to understand these differences.
  • Leaving shares for cost basis step-up: In relation to the tax liability created from deferring the realization of gains, it is possible that the liability may never be repaid. In the case of death, the securities in an investor's portfolio will have their cost basis reset at the current price and any tax liability stemming from deferring the realization of gains will not have to be repaid.
  • Donating appreciated shares to charity: Similar to leaving shares for cost basis step-up, donating appreciated shares to charity is another potential way to improve an investor's tax efficiency. A tax deduction may be taken for the full market value of any securities with unrealized long-term gains that are donated to a public charity. Donor-advised funds are a readily available way to easily facilitate the donation of appreciated securities.
  • Planning your income withdrawal during retirement: The most common withdrawal strategy is to: 1) take your required minimum distributions from retirement accounts, 2) take from your taxable accounts, 3) dip into any tax-deferred account, like a traditional individual retirement account (IRA) or 401(k) and 4) finally, to take the money from tax-exempt accounts, like a Roth IRA. However, this may not be the correct strategy for you. Having a wealth advisor collaborating with your tax professional can play an important role in planning your income withdrawal strategy during your retirement years.
  • Maintaining a disciplined investment approach: RSM US Wealth Management takes a long-term, strategic view when it comes to investment management. This approach allows us to take advantage of several of the points made above. In contrast, if an investor were to rebalance their allocation too frequently or were to place many trades in an attempt to time the market, these actions would likely increase an investor's overall tax burden.

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