As the year comes to an end, many people reflect on the time that has passed, holidays that are near, and family gatherings to come. It seems like no matter how well you plan to host holiday dinners there is always a wrench that gets thrown in – forgotten bread, undercooked turkey, or an unannounced guest. Year-end tax planning seems a lot like the holiday dinners. You spend much of the year not thinking about it, and as it draws near you get more anxious on trying to get it done right. Like holiday dinners, there is a degree of uncertainty in tax planning; some things you can control and some things you cannot. Here are three major investment-related tax planning items that you can control, asset location, loss harvesting, and avoiding year-end capital gain distributions.
Year-End Tax Planning Tool 1 – Asset Location
Asset location is an important part of building a tax efficient portfolio. Investors who own different account types such as IRAs, Roth IRAs, or taxable accounts have the opportunity to improve after-tax returns. Asset location works because some assets make large distributions in the form of either ordinary income or capital gains. Buying funds that make large ordinary income or capital gain distributions would be better suited for a qualified account (IRAs, 401ks, etc.) rather than a taxable account. Funds that make these distributions are not doing it because they are poor funds. They make these distributions because the underlying asset class is more prone to pay out those distributions.
Real estate is a good example in which most of the distributions are considered ordinary income. Income is one of the largest sources of return in real estate. By purchasing this in a qualified account, you defer having to pay tax on the ordinary income until you start to draw down on that account. Your return is improved because you defer paying tax for a later time. Asset location is a great year-end tax planning tool to squeeze extra return from the same asset.
Tool 2 – Loss Harvesting
Loss harvesting means selling positions in the portfolio that are held at a loss. It also is a process that should occur throughout the year instead of just at the end. Loss harvesting doesn’t mean that you have to completely lose the exposure either. Consider a portfolio that holds an oil company at a loss. You might want to realize the loss, but you don’t want to lose your exposure to oil. The solution to this would be to sell the oil company and buy another oil company of similar characteristics. Doing this means that you get to realize the loss and keep your oil exposure. To avoid the wash sale rule, you can rebuy the oil company that you sold after 30 days.
It is important to look for opportunities to realize losses on an ongoing basis. Only looking at the end of the year ignores the variation in stock prices throughout the year. Frequently reviewing the portfolio for loss harvesting opportunities and taking advantage of them can improve the after-tax return of the portfolio.
Tool 3 – Capital Gain Distributions
Capital gains are usually triggered when you sell an investment. Mutual funds, however, can trigger capital gains even if you don’t sell the fund. This is because mutual funds are required to pass the gains they realize to their investors in the form of capital gain distributions. There are limited ways to avoid them, but the best ways to do so is to avoid tax inefficient funds, sell before the distribution, or use ETFs where possible.
Funds can be tax inefficient for a variety of reasons, but one example is if their investment strategy involves high turnover – lots of selling and lots of buying. Funds like this are usually the more aggressive type and are trying to keep their desired exposure. For example, a growth-oriented fund might kick out a stock if its performance wanes. If this happens often and the fund has nothing to offset the gains, a year-end capital gain distribution may be made.
Most capital gain distributions are made at the end of the year and are announced ahead of time. This lead time allows us to look for opportunities to avoid them. We will sell mutual funds ahead of time for clients who hold a mutual fund at a loss that is expected to make a capital gain distribution. Much like the loss harvesting oil example mentioned before, we’ll use the proceeds to buy another similar fund to keep the exposure. After 30 days, we’ll buy back the fund we prefer.
Lastly, to avoid capital gain distributions we will use an Exchange Traded Fund (ETF) equivalent to our preferred funds where possible. ETFs tend to make very little capital gain distributions. To put it in perspective, Morningstar estimates that of the nearly $540 B of capital gain distributions made in 2018 only 1% of that was caused by ETFs – the rest caused by mutual funds. The migration from high cost, actively managed funds to low cost, index-based funds is a big driver of this. This is a major phenomenon in the investment world that is a topic all of its own.
These are just a few examples of investment-related year-end tax planning items to consider. The good news is that clients don’t need to worry about any of these. A major part of our investment selection process involves identifying what is better to buy and which account types that investment is more appropriate for. By making asset location decisions we can squeeze more return from the same asset. We do this by utilizing the power of tax deferral to shield against ordinary income or capital gain distributions. Our ongoing investment managing involves frequent review of loss harvesting opportunities throughout the year, rather than just at year end. This is more consistent with how stocks move. The stock could have been down all year, but at December it is no longer at a loss and with it the opportunity to realize that loss is gone. As always, keep us apprised of changes or potential changes of your circumstances, however small you may think. Our financial planning and investment professionals are your resource in partnering for financial well-being.
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.
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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.