"What is the difference between a taxidermist and a tax collector? The taxidermist takes only your skin." – Mark Twain
Financial markets are unpredictable. Some years are very good, some years are very bad, while most are somewhere in between. Over time, investors who employ thoughtful diversification strategies ought to get paid for taking on this uncertainty. With the exception of the entrepreneurial business owner, a good rule of thumb is for investors to avoid having all their eggs in one basket.
The most difficult periods for both investors and their managers are when financial markets have a big down year coupled with capital gains taxes coming due on previously realized profits. It’s a double whammy and unfortunately this is exactly what happened to many investors in tax year 2022, as profitable positions were unwound by investment managers in an attempt to minimize risk.
As an investment adviser, the balancing act which must be considered when managing taxable portfolios is how to risk manage the uncertainty of the market against the known quantity of realized capital gains tax. Sometimes it makes sense to stay fully invested and let it ride, while at other times taking profits and paying tax is the best overall strategy. Knowing when to do what separates good outcomes from bad outcomes.
I am the son of a tax accountant. My father instilled in me the necessity of tax aware strategies when managing investments. Unlike many accountants however, my father consistently stressed the importance of focusing on market returns as the driver, followed by the consideration of potential tax consequences. To be clear, the role of investment management is first and foremost achieving acceptable risk adjusted returns.
With that said, as we roll into year-end, I thought now would be a good time to go over tax aware strategies. Below is a piece recently put out by American Century Investments, which can be useful for both professional and non-professional investors alike.
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Three Tips To Help Temper Taxes
By Sandra Testani, CFA, CAIA
American Century Investments
As most investors know, investment returns alone don’t mean much. Rather, we believe its after-tax investment returns that matter. Investing with an eye on taxes should be a year-long effort. Waiting until tax season may mean missed opportunities to take advantage of important strategies throughout the year. Adhering to three ongoing efforts—harvesting tax losses, managing distributions and thinking strategically—may improve the overall tax efficiency in your clients’ portfolios.
Harvest Tax Losses
While losses are never the goal, losing money in an investment can sometimes have an upside. With a tax- loss harvesting strategy, investment losses in one or more investments can help offset gains in others, which may result in a lower overall tax liability. Investors can use their realized losses to offset capital gains or ordinary income, up to $3,000 in a single year for joint filers ($1,500 for single filers), according to the Internal Revenue Service (IRS). Investors may carry forward any additional losses indefinitely. The IRS provides guidance on the amount you can carry forward or consult with a professional tax consultant. Let’s take a look at Figure 1 for a hypothetical example of how tax-loss harvesting can work:
When using the tax-loss harvesting strategy, it’s important to keep a few things in mind:
• Be mindful of the IRS’s wash sale rule. This rule prohibits the purchase of the same or “substantially identical” security within 30 days (before or after) of selling that security at a loss. You also may not sell a security at a loss in a taxable account and purchase that same security for a tax-deferred account within 30 days of the sale. However, you may purchase a similar investment to maintain exposure to that industry or sector.
• Know your alternatives. Consider the relative advantages and disadvantages of using ETFs, active mutual funds or indexed mutual funds to replace a security sold at a loss.
• Don’t let taxes alone drive the sell decision. Before harvesting tax losses, make sure the sale makes sense for the overall investment strategy and client goals.
• The strategy works for taxable accounts only. There’s no benefit to harvesting losses in a tax-deferred account.
Manage Capital Gains and Dividends
Monitoring distribution timelines and investment holding periods—and determining if or when to buy or sell specific assets—are important components of a comprehensive investment strategy. These planning efforts can make a big difference in the portfolio’s yearly tax bill.
Regarding capital gains, the holding period is crucial. How long your client owns an investment before selling it at a profit will determine the tax liability. Selling an investment owned for less than one year triggers a short-term capital gain, while exiting an asset owned for more than a year causes a long- term capital gain.
In general, long-term capital gains receive more favorable tax treatment than short-term gains, which are taxed as ordinary income at marginal rates as high as 37%. The maximum tax rate for long-term capital gains is 20% (see Figure 2).
Similarly, dividends receive different tax treatment depending on their classification. Qualified dividends are taxed at the same rates as long-term capital gains. Non- qualified dividends are treated as ordinary income for tax purposes, taxed at regular income tax rates of 10%, 12%, 22%, 24%, 32%, 35% or 37%. To be “qualified,” a dividend:
• Must be paid by a U.S. corporation or qualified foreign entity.
• Cannot consist of premiums or insurance kickbacks, annual distributions from a credit union or dividends from co-ops or tax-exempt organizations.
• Must meet holding period requirements, which differ for each asset type.
There are other important dates and timelines to consider regarding capital gains and dividend distributions (see Figure 3). In most cases, given a two-day settlement period:
• If you buy a security before the ex-dividend date, you will receive the dividend (or capital gains distribution).
• If you buy a security on the ex-dividend date, you will not receive the dividend (or capital gains distribution).
• If you sell a security prior to the ex-dividend date, you will not receive the dividend (or capital gains distribution).
• If you sell a security on the ex-dividend date, you will receive the dividend (or capital gains distribution).
Plan Strategically
Over time, the effect of capital gains distributions can add up, cutting into your client’s long-term profits. Consider these figures for a hypothetical $100,000 investment in the average U.S. large-cap stock mutual fund, according to Morningstar. For the period 2012 through 2022:
• Assuming an average annual return of a little over 10%, the portfolio’s pre-tax value at the end of the 10-year period was nearly $264,609.
• The average annual tax cost for the period was 1.83%, or $2,672—more than double the average expense ratio of 0.82%.
• The total tax bill for the 10-year holding period was approximately $46,709, cutting the after-tax portfolio value to $217,900.
Limiting the effect of taxes on a portfolio’s long-term performance requires ongoing attention to the portfolio’s holdings. Perhaps most importantly, consider tax-efficient investments, such as ETFs. Compared with actively managed mutual funds, many ETFs experience lower turnover—and therefore, fewer taxable events. In addition, the ETF structure is generally more tax friendly than most mutual funds. When mutual fund investors redeem shares, the fund may have to sell securities to meet the redemptions. And those sales may trigger capital gains for the fund and all its shareholders. But when ETF investors sell shares, they sell those shares to other investors, resulting in no taxable gains for the ETF.
In addition to using tax-efficient investments to create a solid foundation in the portfolio, other tactics to consider also may help limit the annual tax bill:
• Pursue a buy-and-hold strategy to reduce turnover within the portfolio.
• Limit exposure to investments that pay taxable distributions several times a year.
• Minimize long-term gains.
• Avoid taking short-term capital gains, which are typically taxed at a higher rate.
• Invest regularly, rather than trying to time the market.
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Regarding markets, I wouldn’t be surprised to see stocks continue higher into year-end, as bond yields adjust lower on the back of less than feared US Treasury bond auction supply. Add into the mix falling inflation numbers and decreasing economic activity and we have a potentially good set-up for bond investors . Both stocks and bonds were pretty beaten up last quarter, so maybe we have some retracement to work through.
Beyond tactical strategy into year-end however, I still believe the lagged effect of tighter monetary and fiscal policy will feed through into financial markets, which means stocks probably have an uphill battle ahead.
Nevertheless, one must play the perceived probabilities, which points to underweight equities on the margin. As for equity sector overweight’s, I continue to like large cap technology and housing related industries, while on the fixed income side, money markets along with intermediate and long term US Treasuries notes and bonds are expected to both balance out portfolios and hopefully start adding to returns.
Sincerely,
Justin Kobe, CFA
Founder, Portfolio Manager & Adviser
Pacificus Capital Management
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Advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Adviser. Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a broker-dealer, member FINRA/SIPC. Cambridge and Pacificus Capital Management are not affiliated. Material discussed is meant for general illustration and/or informational purposes only, and it is not to be construed as investment, tax, or legal advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. These are the opinions of Justin Kobe and not necessarily those of Cambridge Investment Research, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing in the bond market is subject to risks, including market, interest rate, issuer credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counter-party capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Diversification and asset allocation strategies do not assure profit or protect against loss.
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