The coronavirus pandemic that has pummeled the stock and bond markets has led many investors to take a closer look at their investment portfolios. While investors are urged to avoid changing their long-term investment strategy during corrections and bear markets, these selloffs can actually create an opportunity to enhance long-term portfolio objectives.
One of the most important concepts in portfolio management is tax-smart investing.
To help understand it, let's first differentiate between retirement and non-retirement accounts. A retirement account, such as a traditional individual retirement account or a 401(k) plan, is not taxed until you start taking withdrawals. A non-retirement account, however, is a taxable account in which you invest after-tax money that you earned or inherited, or that was created when you sold a capital asset, such as a property.
The tax efficiency of your non-retirement portfolio is an important consideration in tax-smart investing. The construction of this portfolio should be driven by a thorough understanding of your tax return profile.
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Here's why: Different investment vehicles have varying tax efficiencies because of their structure. Mutual funds that invest in stocks, for example, are often very tax-inefficient compared to portfolios of individual stocks or exchange traded funds because of the mutual fund's potential for annual capital gains distributions.
When a mutual fund distributes a capital gain, investors have the option of taking the distribution in cash or reinvesting in more shares of the mutual fund. In both cases, the capital gains distribution from a mutual fund owned in your taxable portfolio will appear on the Schedule D of your tax return. These capital gains can be a "tax drag" on the portfolio, which is a phantom cost that many investors are unaware of and common pain point among people in high tax brackets.
If you are an investor who has a tax-inefficient non-retirement portfolio, all is not lost: A qualified financial advisor or CPA can show you if your taxable investments can be tax-efficiently rebalanced over time to achieve a tax-smart portfolio, which is a two-part process.
The first part is through tax-loss harvesting. This strategy is when you sell all or some of your investment holdings at a loss concurrent with an offsetting sale of all or some positions with roughly an equal amount gain. The net effect is creating cash without triggering much of a tax gain or loss, and this cash can be redeployed into tax-efficient holdings, thus creating a more tax-smart non-retirement portfolio.
If you've been invested in a mutual fund for several years and your capital gains distributions have been reinvested, each of these reinvestments has a specific cost basis, known as a tax lot. For example, the capital gains reinvestment that happened last year is a tax lot with a cost basis that is likely different than the capital gains reinvestment that happened five years ago.
Oftentimes, your account statement will report an average cost basis of these tax lots, but your taxable account's cost basis information can be converted to show the cost basis for each tax lot.
When market selloffs occur, it's a great time to review which tax lots are eligible for tax-loss harvesting. Buy-and-hold investors often don't want to sell during corrections or bear markets, but if the same market exposure — such as growth stocks — is available in a more tax-efficient structure, conducting tax loss harvesting when markets are down can be an opportune time to create a tax-smart portfolio.
Waiting for markets to recover could mean that the tax-loss harvesting opportunities that were available during a market maelstrom may no longer be available, and you may have to pay capital gains taxes to sell all or part of a tax-inefficient holding to reinvest in a tax-smart holding.
The second part is through tax-bracket management. This is when you harvest gains in your non-retirement portfolio without jumping into a higher marginal tax bracket. It is important to start with the holdings that have appreciated the least, because selling these will allow you to create more liquidity with less capital gains. It's key to consult a qualified tax professional before making any modifications to your non-retirement account.
Tax-loss harvesting and tax-bracket management are not mutually exclusive. Together, they can reduce the tax drag on your non-retirement portfolio, thus allowing more of your money to participate in long-term investing. Both strategies can be implemented over time and should be revisited annually, and during market selloffs, to help you implement a tax-smart portfolio.
— By Vance Barse, wealth strategist and founder of Your Dedicated Fiduciary