As we approach the year end, many investors, including retina specialists, are examining their portfolios to see “how they did” for the year. Unfortunately, for too many investors, the focus will be on their investments’ gross returns, which are often easily calculated, rather than the net after-tax returns, which are much more important. For any ophthalmologist who is investing to reach one or more financial goals—such as retirement, children’s education, or a second home—the net after-tax returns are all that really matter.
Consider this simple question: would you rather earn a 7% return that nets you 6.5% after taxes or an 8% return that nets you 6% after taxes? The answer should be clear—the 6.5% post-tax return is superior.
In this article, we provide you with a five-point checklist that can help you reduce the taxes on your investments. These tactics can be especially beneficial as part of a year-end investment review.
USE YOUR ASSET LOCATION WISELY
Many are familiar with the term “asset allocation” as it relates to a portfolio. However, a common mistake many investors make is failing to implement an asset location strategy. Individually owned brokerage accounts, Roth IRAs, and qualified plans are subject to various forms of taxation. It is important to use the tax advantages these tools provide to ensure they work for you in the most productive manner possible.
As an example, investment vehicles paying qualified dividends are preferred in an individual or joint brokerage account, while it is generally recommended that qualified accounts own high-yield bonds and corporate debt taxed at ordinary income rates. There are countless additional examples, but the lesson is that it’s important to review the pieces of your plan with an advisor who will consider both asset allocation and asset location as they relate to your specific circumstances.
CONSIDER HOLDING PERIODS
Long-term capital gains rates are much more favorable than short-term rates. Holding a security for 12 months or longer presents an opportunity to save nearly 20% on the taxation of your appreciated position. For example, an initial investment of $50,000 that grows to $100,000 represents a $50,000 unrealized gain. If an investor in the highest tax bracket simply delays liquidation of the position (assuming the security price does not change), the tax savings in this scenario would be $9,800.
Although an awareness of the holding period of a security would appear to be a basic principle of investing, many mutual funds and managed accounts are not designed for tax sensitivity. High-income investors need to be cognizant of this fact. Therefore, it is generally advantageous to seek the advice of a financial professional who is aware of holding periods and has experience executing an appropriate exit strategy.
IMPLEMENT PROACTIVE LOSS HARVESTING
One benefit of holding a diversified portfolio is that, if structured properly, the securities typically will not move in tandem. This divergence of returns among asset classes reduces portfolio volatility and creates a tax planning opportunity. When some holdings within a portfolio experience gains, while others decline, an astute advisor can use this situation to save clients thousands of tax dollars by performing strategic tax swaps before year-end. When executing such tactics, it is important to understand the rules relating to wash sales. Because the laws are confusing and mistakes can result in additional tax liability, you should make certain your advisor is well-versed in tax-loss harvesting.
USE APPRECIATED ASSETS CHARITABLY
Successful investors can occasionally find themselves in a precarious position. You may have allocated 5% of your portfolio to a growth stock with a significant upside. Several years have passed, the security has experienced explosive growth, and it now represents 15% of your investable assets. Suddenly your portfolio has a concentrated position with significant gains, and the level of risk is no longer consistent with your long-term objectives. The sound practice of rebalancing your portfolio then becomes very costly because liquidation of the stock could create a taxable event that may negatively impact your net return.
By planning ahead, you may be able to gift a portion of the appreciated security to a charitable organization able to accept this type of donation. The value of your gift can be replaced with the cash you originally intended to donate to the charitable organization; and, in this scenario, your cash will create a new cost basis. The charity can then liquidate the stock without taxation, and you have removed a future tax liability from your portfolio. Implementing this gifting strategy offers the potential to save thousands of dollars in taxes over the life of your portfolio—and helps a worthwhile cause in the process.
BE COGNIZANT OF MUTUAL FUNDS’ TAX COST RATIOS
Although the technical details behind a mutual fund’s tax cost ratio are beyond the scope of this article, we would be remiss if we didn’t bring this topic to your attention. The tax cost ratio represents the percentage of an investor’s assets that are lost to taxes. Mutual funds avoid double taxation, provided they pay at least 90% of the net investment income and realized capital gains to shareholders at the end of the calendar year. But not all mutual funds are created equal, and proper research will allow you to identify funds that are tax efficient.
A well-managed mutual fund will add diversification to a portfolio while creating the opportunity to outperform asset classes with inefficient markets. Still, you need to be aware of funds with excessive turnover. Moreover, understanding when a fund pays its capital gains distributions is critical. Here’s the bottom line: Understanding the tax cost ratios of the funds that make up portions of your investment plan will enable you to take advantage of the many benefits of owning mutual funds.
TAX ADVICE MATTERS
Implementation of one of these tactics alone, in any given year, may not make a huge dent in an ophthalmologist’s tax bill. However, in combination and over time, they can significantly reduce your taxes and increase your net investment returns. Physicians should choose an advisor who will help them look beyond portfolio earnings and focus on strategic after-tax asset growth.
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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice, or as a recommendation of any particular security or strategy. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.
