In 2016, a 20 percent tax on qualified dividends and long-term capital gains for taxpayers with taxable income over $466,950 ($415,050 for single filers) will be in effect for its fourth year. Also, a 3.8 percent Medicare surtax on investment income for taxpayers with AGI exceeding $250,000 ($200,000 for single filers) will be in effect for its fourth year. These changes have made it more even more important to reduce the tax drag on your portfolio. Below are 5 ideas to make your portfolio more tax efficient.
Allocate tax inefficient investments in tax deferred accounts
Investments considered least tax efficient are those that generate investment income that is taxable at your ordinary income tax rate (interest income, ordinary dividends, and short-term capital gains). If your taxable income is over $466,950 ($415,050 for single filers), this income will be taxed at a whopping 43.4%! Even investments that generate income with more favorable tax treatment (qualified dividends and capital gains) will be taxed at a rate of 23.8% if your taxable income is over $466,950 ($415,050 for single filers).
It is important to allocate investments with a high propensity to generate investment income to tax deferred accounts (IRA, 401k, 403b, Deferred Compensation Plan, variable annuities) in order to delay taxation of this income, with the intent of withdrawing from these accounts when you are in a lower tax rate in the future. Investments that have a high tendency to generate investment income include:
- Taxable fixed income – Taxable fixed income securities, ETFs, and mutual funds generate ordinary income, making these investments particularly tax inefficient.
- High turnover mutual funds – Mutual funds that have a high turnover (frequently buy and sell investments) are more prone to generate short, and long-term capital gains. When these gains are realized, they must be distributed annually, and are taxed to the holder of the fund.
- High dividend paying equity funds & REITS– These funds will generate a high amount of dividends, most of which are likely to be taxed at the qualified capital gain rates (23.8% for high income earners).
- Alternative Investments – Because many alternative investment strategies have high turnover, and/or employ derivative/options strategies, these funds are likely to be more tax inefficient than a long-only equity strategy.
Use high growth, tax inefficient investments in tax-free (Roth) accounts
Because Roth account income and ordinary distributions are tax free, the more the account grows, the more beneficial it will be to the owner. Roth accounts should hold assets that are tax inefficient, but have the highest expected rate of return. For a Roth account, look for an investment that displays some of the tax inefficient characteristics listed above and has the highest growth potential. High turnover or high dividend paying small cap funds are good examples of investments that should be held in a Roth account.
Incorporate municipal bonds into your after tax accounts
Municipal bonds are fixed income products issued by municipalities, and are generally federal income tax free to the investor (with some exceptions). These investments will add another layer of diversification to your portfolio, and will provide a stream of tax-free income. Because the income generated from these investments is (typically) tax-free, these investments should be held in your taxable accounts.
Use low-turnover funds, individual securities, and international allocations in after tax accounts
Low-turnover mutual funds and ETFs are investment strategies that do not frequently buy and sell holdings in their portfolios. Many of these strategies are either buy and hold strategies, employed by an active fund manager, or passive index strategies. Because capital gains realized by these strategies are minimal, they leave the decision up to the investor as to when they would like to realize the capital gains (by buying or selling the fund). Individual stocks give investors even more flexibility to control capital gains realization within after tax accounts. For this reason it is best for buy and hold investors to retain these investments in after tax accounts.
A foreign tax credit is available for foreign taxes paid on investments. This credit can only be claimed if the investment is held in a taxable account, making it beneficial to hold low-turnover, international funds, in your taxable brokerage account(s).
Take advantage of capital loss/gain harvesting
In years that investments in your taxable accounts have unrealized losses, you can sell the investments, and realize the losses. To the extent that your realized losses exceed your realized gains, you are able to offset up to the annual limit of $3,000 ($1,500 if you are married filing separate) against your taxable income. If you are in the 39.6% tax bracket, this deduction equates to $1,188 in tax savings. High income earners should use market corrections to actively harvest losses via moving sideways into equivalent securities.
In years that you are not in a high income tax bracket, long-term capital gains may be taxed at a lower 15%, or even a 0% rate. It is important to know when capital gains will be taxed at these lower rates to harvest capital gains while you are in a lower tax bracket. By utilizing this capital gains harvesting strategy, you are stepping up the basis in your investments with little or no tax ramifications.
It is important to understand the complex U.S. tax code before implementing these techniques. Click here for a chart of the 2016 marginal tax rates for various types of income in 2016 to determine what income tax rates you are subject to (courtesy of Michael Kitces). Because every situation is unique, you should strongly consider seeking the help of a financial advisor, to ensure your portfolio is allocated properly and optimized for tax efficiency.
-Adam Glassberg CFP®, CIMA®