Tax Planning and Your Investment Portfolio



July 13 , 2018 | Posted by Brad Schueler |

Tax Planning and Your Investment Portfolio

Summertime is back upon us and brings with it a break from school for families, summer vacations, and generally a more relaxed pace of life.  The stock market has gotten off to a volatile start this summer.  Market volatility can lead to rebalancing of a portfolio, which may, however, lead to tax consequences from capital gain generation.  With this in mind, when it comes to investing, there are a few misguided practices that can cost an investor money, either in investment returns or taxes:

  • Treating tax-loss harvesting as a year-end event
  • Handling the taxes in a portfolio as stand-alone instead of understanding its impact on a person’s overall tax situation

First, we address tax-loss harvesting.  We review our diversified taxable portfolios regularly for tax-loss harvesting opportunities.   Part of the benefit of a diversified mix of assets is certainly the smoothing effect (when one asset class is down, another is up).  Additionally, in a taxable account, the ability to capture a tax loss (a tax asset) when an investment is down by selling it, and replacing it with one that may still give us general exposure to this area of the market, but is different enough in nature to not trigger the wash sale rule.   Doing this will allow us to either take this loss and offset up to $3,000 per year of ordinary income on your tax return, or at least offset future capital gains that will be taken as a natural part of managing the portfolio over time (thus reducing taxes).

Only reviewing the portfolio at year-end will minimize the tax loss opportunities available.  See the below chart for the YTD 2018 performance of the Small Cap Value Asset Class which displays this concept:

Second, and more importantly, we address the management of a portfolio in light of a client’s overall tax situation.  To view a single investment portfolio as a standalone tax entity would be a mistake.  Many automated investment services offer investing that seeks to always remain tax neutral, or even to minimize taxes from the portfolio at all costs.  If this is our approach, we naively miss the bigger picture of a client’s situation, and it’s these details that will ultimately drive what your tax liability is.  A few real world examples make this point:

  1. You sold a business in 2018 and have a large capital gain that will impact your tax return. With the proceeds from your business sale you establish a taxable portfolio.  If losses in any of your investments are created in the portfolio, it would benefit you to capture these to offset the larger than normal capital gain generated from the sale of the business (a one-time event).  To remain “tax neutral” in this portfolio, in this particular year, would be a mistake because it neglects your broader financial circumstances uniquely present this year.
  2. With the new tax legislation beginning in 2018, you went from always itemizing your deductions to, all things being equal, taking the standard deduction each year. You’re charitably inclined, have been giving at about the same levels to the same organizations for years, and have enjoyed a tax write-off for doing this. The tax benefit has gone away since you’re taking the newly raised standard deduction now whether you give to charity at the same level or not.  Being cognizant of this, the next time we are rebalancing your portfolio (inevitably selling something that has done very well and has a capital gain to purchase an asset class that has trailed) we would first consider gifting an appreciated security into a donor advised fund to bunch multiple years of charitable giving into a single year.  Doing this can accomplish a few things:
    • Reduces back to acceptable diversified levels the asset that has performed so well, rebalancing the portfolio
    • Allows you to take the itemized deduction benefit for your charitable giving this year
    • Minimizes the capital gains generated during the portfolio rebalance
  1. You recently retired, you and your spouse are 64 years old, plan to take Social Security at age 67, and you have a mixture of 401k, IRA, and taxable assets. You plan to live exclusively off of taxable assets for three years and then will have a combination of social security income and your investments to sustain your lifestyle.  With no plans to withdraw from 401k and IRA assets for three years, you will have no ordinary income to report on your tax return.

In the first two tax brackets of the tax code (10% and 12% brackets) you pay a 0% federal tax rate on qualified dividends & long-term capital gains.  In this scenario, trying to minimize long-term capital gains taken may be a mistake.  It very well could make the most sense to “tax gain harvest” up to a level to ensure you capitalize, to the extent possible, on recognizing these gains while you’re still able to do so with no tax liability.  This would set your portfolio up to be more tax efficient long term by resetting your cost basis on these securities to a higher level, thus generating less capital gains down the road.

As you can see, managing taxes in an investment portfolio is an important and ongoing responsibility.  It’s important throughout the year, as the opportunities present themselves, to take advantage of fluctuations and changing life circumstances.  Even more important though is helping clients gain clarity when it comes to their financial future.  In this way, we’re going to be able to make tax savvy decisions that span not only your lifetime, but even have generational impacts on those you love.