2014 tax primer: In search of gamma


When it comes to managing portfolios, taxes are one of the biggest expenses investors face. So now that we are in the thick of tax season, it’s time to review some basic precepts of effective tax management.

In a taxable account, the choices an investor makes regarding tax strategy can have a huge impact on returns and portfolio wealth accumulation over the long haul. Failing to fortify your portfolio with tax-friendly investments can be costly, says Kimberly Clouse. “Taxes can have a significant impact on returns,” she said in a recent installment of Covestor Radio.

Tax strategy matters: Consider this example from the folks at BlackRock’s iShares group: Imagine a $10,000 five-year investment assuming an annual return of 4% at current tax rates. By year five, the return would be $15,297 and the tax cost would be $5,738.

Morningstar Investment Management’s head of research, David Blanchett, created a new metric he calls gamma to scope out the benefits that smart financial planning (including tax planning) can have on a portfolio.

In a 2013 research paper, he found that asset location (strategically placing certain kinds of investments in certain types of accounts for tax efficiency) as well as carefully timing withdrawals from retirement accounts can add up to 3%-plus in average additional income. Given how scarce yields are these days, that’s not chump change.

How to get there? Every investor has unique tax situations and it’s always wise to consult with a tax expert. However, here are a few tips the financial pros think are worth a serious look to keep tax bills to a minimum.

Tax loss harvesting

Selling losers in your portfolio to recognize a loss for tax purposes is a technique called tax loss harvesting. Investors employ these losses to reduce capital gains and a portfolio’s overall tax bill. In addition, you can bank these tax credits and carry them forward in future years as needed.

Tax-loss harvesting does have some limitations. The IRS frowns on dumping a stock for tax purposes—and then quickly turning around and buying it back, a so-called wash sale. U.S. tax authorities require that you wait at least 30 days before repurchasing a “substantially identical” security.

Municipal bonds

These tax-exempt securities have hit a tough patch as bankruptcies in Detroit and the Californian cities of Stockton and San Bernardino have shaken the faith of investors. Rising Treasury bond yields over worries the Fed’s easy money policies were coming to an end last year also didn’t help. Investors withdrew a net $58 billion from muni mutual funds last year as returns deteriorated. However, overall state finances have been on the upswing.

For high-income workers, munis may make sense. With the top federal income tax rate to 39.6%, not to mention a new 3.8% tax on investment income for high earners that was included in the Affordable Care Act, municipal bonds can help reduce the tax bill on your portfolio. There are a lot of good online calculators like this one to help investors determine if these securities are right for them.

Dividend and capital gains timing

Timing is everything when it comes to dividends. For instance, if you hold a fund that will soon pay a dividend, you have some math homework to do. Investors ought to weigh the tax cost of recognizing a dividend payout against the gain of selling the fund. It pays to keep track of dates funds plan to pay out dividends–and the size of the dividend—to map the most effective tax strategy.

Another tip: Investors should get in the habit of checking if their mutual funds or ETFs are making capital gain distributions this month. If the fund has already delivered handsome returns, it might make sense to sell before that capital gain distribution to lower your tax bill.

Tax lot identification

Tax experts say it pays to keep careful records of individual stock purchases rather than averaging out the cost of a big position. This pertains to investors who have accumulated sizable positions in stocks or funds over the years with multiple purchases. If you want to sell part of this holding, make sure you have records on specific lots. You then have the flexibility to sell strategically to minimize your capital gains tax hit. It doesn’t apply to every transaction, but it is a good habit to keep.

ETFs and index funds

Passive funds can be very tax efficient. That’s because every time a mutual fund or managed account buys or sells a position it generates a taxable event. All of these transactions—the more turnover, the higher the tax bill–get reported to the IRS. Index funds by nature have less turnover and represented in a portfolio can improve its performance on a tax adjusted basis.

Photo Credit: kenteegardin

DISCLAIMER: The information in this material is not intended to be personalized financial and/or tax advice and should not be solely relied on for making financial decisions.  Please note that the information being provided is strictly a courtesy.  Covestor and its representatives do not provide tax or legal advice.  Please consult your tax advisor or attorney for such guidance.  Past performance is no guarantee of future results.