As we near the end of the year, it is important to review if any transactions you have made throughout the year have tax consequences. It is especially important to see if there is any way to offset tax consequences before the year ends to mitigate tax bill surprises. At RegentAtlantic, we view tax planning as a constant process that begins from the moment your portfolio is managed with us and evolves over time with your changing circumstances, life events, and goals. It may be helpful to review some of the steps we take throughout the year to improve the tax efficiency of your portfolio.
Investments generate return in two ways: income and capital gains. Some investments generate predictable income returns, while others tend to generate much of their returns through capital gains. We generally will place assets that consistently generate high income or capital gains in tax-sheltered accounts. Tax-sheltered accounts offer the ability to defer paying taxes until withdrawals are made.
Being able to defer paying tax can increase total returns. To illustrate this, let’s draw a scenario in which someone buys a high income producing asset in their taxable account that earns 7% per year for 30 years. Since this is in a taxable account, this person pays 37% tax on the return of this asset every year.
Let’s also draw a scenario in which this same person buys the same asset, but instead places it in a tax-sheltered account for 30 years and withdraws the entire amount at the end. Since this is a tax-sheltered account, this person pays 37% tax on the final amount.
In the example above, by simply buying the asset in a tax-sheltered account increased after-tax returns by approximately 1% per year.
Rather than looking to realize losses at the end of the year, we look to realize losses throughout the year – particularly if there is a correction. Losses offer an opportunity to reduce the amount of realized gains and reduce your tax bill. Many investors do loss harvesting only at the end of the year, but this ignores the inherent volatility of the stock market.
After all, the lowest point in the stock market is generally not where the market ends up closing for the year. In some cases, the market closes the year with a positive return after experiencing deep losses, so the year-end loss harvester may miss intra-year losses. Although loss harvesting throughout the year may not be able to capture the absolute lows of the market, it at least gives you a chance to capture losses more often.
Year-end gifting of stock is a good way to avoid realizing gains and offers a way to manage risk. Stock gifting is usually accomplished by using the highest appreciated stock in the portfolio. When you gift highly appreciated securities, you get a deduction for the full value of the stock without realizing a taxable gain. Compared to donating cash, selling the stock first and then gifting the cash would incur a taxable gain.
By identifying assets that consistently make large distributions and locating them in a tax-sheltered account, we can improve the return of the portfolio. In the example above, we were able to extract more return from the same asset by simply owning it in a different account type. Loss harvesting is a process that we run throughout the year to help reduce taxes. As market losses are unpredictable, regular loss harvesting has the potential to realize more losses. Gifting stock will allow you to take a deduction on the full value of the stock and provides an opportunity to avoid realizing gains on highly appreciated positions.
Important disclosure information
Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable.
Please remember to contact RegentAtlantic if there are any changes in your personal or financial situation or investment objectives for the purpose of reviewing our previous recommendations and services, or if you wish to impose, add, or modify any reasonable restrictions to our investment management services. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.
This article is not a substitute for personalized advice from RegentAtlantic. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed in other businesses and activities of RegentAtlantic. Descriptions of RegentAtlantic’s process and strategies are based on general practice and we may make exceptions in specific cases.
RegentAtlantic does not provide legal or tax advice. Please consult with a legal and or tax professional of your choosing prior to implementing any of the strategies discussed in this article.