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7 ways to make your clients' portfolios tax efficient

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With the year end upon us, savvy investors will once again be reviewing the tax efficiency of their retirement and investment portfolios. For many, the tax pain caused by the recent changes under the American Taxpayer Relief Act (ATRA) is still fresh in their mind.

ATRA not only increased the top income tax rates but also reduced the value of certain tax expenditures such as itemized deductions and personal exemptions for some taxpayers. But for many, the biggest tax increase was on their investment income.

ATRA increased the top tax rates for long-term capital gains and qualified dividends from 15 percent to 20 percent. In addition, many are now subject to the 3.8 percent Medicare surtax introduced as part of the Patient Protection and Affordable Care Act (PPACA) in 2013. This is an additional tax on certain investment income for those that make over $200,000 single filer and $250,000 for joint filers.

As a result of this surtax and the increased top tax rate for capital gains, there are now four different tax rates for long-term capital gains and qualified dividends depending on the taxpayer’s income. For those in the bottom two income tax brackets, there is no tax on long-term gains and qualified dividends.

For those in the 25 percent tax bracket, the tax is 15 percent. For those that are subject to the 3.8 percent surtax, the tax increases to 18.8 percent. Those in the highest tax bracket will be subject to a 23.8 percent long-term capital gain and qualified dividend tax. It’s getting more complicated.

Although ATRA affected the wealthiest taxpayers the most, as it was designed to do, the biggest tax hike actually happens at the $37,450 level for a single filer and $74,900 for a married couple filing jointly.

This is where a taxpayer goes from a 15 percent to 25 percent tax bracket. That is a 66 percent increase. For those taxpayers, tax bracket management, tax timing and tax efficient investing can be powerful tools in reducing taxes. Furthermore, by keeping in the 15 percent tax bracket, their long-term capital gains and qualified dividends will be tax free.

Strategies to reduce income taxes

There are strategies available to all clients in all tax brackets that may help them manage their taxes, control the timing of their taxes, keep them in a lower tax bracket and reduce their actual tax liability. The following are a few to consider as the year end approaches.

slinky money

1. Reduce income:

A simple way to reduce taxes is to reduce the income subject to tax. Taxpayers should consider maximizing contributions to 401(k) plans, IRAs, Spousal IRAs for non-working spouses and catch up contributions into those accounts for individuals 50 and over.

An increasingly popular way to reduce income is by contributing to a Health Savings Account (HSA). Those that enroll in a high deductible health insurance plan (a plan with a minimum deductible of $1,300 for single and $2,600 for a family), can make contributions into an HSA up to $3,350 for a single and $6,650 for a family. Think of it as a “health IRA.” The contributions are tax deductible regardless of income, grow tax deferred and can be withdrawn tax-free to pay for qualified medical expenses.

Also, it is portable, meaning when you change jobs you can take it with you. Furthermore, HSAs are not a ‘use it or lose it’ account. The taxpayer can pay for out-of-pocket medical expenses with money out of their pocket, allowing the HSA to continue grow tax deferred. When the taxpayer retires, tax free distributions from HSAs can be used to pay for out-of-pocket Medicare expenses such as premiums (other than premiums for Medigap insurance), deductibles and co-pays.


2. Maximize deductions:

Clients should work with their tax preparers now to make sure they do not overlook any valuable deductions. Further-more, they may want to consider accelerating deductions by paying real estate taxes and 2016 mortgage payments in 2015. Of course, don’t ignore how this may affect possible exposure to the Alternate Minimum Tax (AMT).

See also: 11 health insurance tax facts you need to know

poor investment

3. Tax loss harvesting:

Taxpayers may want to consider whether it makes sense to dump some of their poor performing investments, and recognize a loss to offset a gain from other investments. Capital losses can fully offset capital gains to $3,000 of ordinary income.

But don’t be tempted to immediately (within 30 days) repurchase the sold investment. The “Wash Sale Rule” will apply and the loss will not be recognized.


4. Conduct a portfolio review:

Many people don’t think about how taxes could affect their long-term investment and retirement goals. The taxes an investor pays annually on capital gains, dividends and interest could significantly erode a portfolio’s return in the future.

Morningstar measures the tax cost ratio of most mutual funds, and while some funds will have a low tax cost ratio, other funds can have ratios as high as 3 percent or more each year. This means that a mutual fund with a 2 percent tax ratio will surrender 2 percent of its returns to taxes each year.

The tax drag will be greater for those funds that are actively managed and have a high turnover ratio. The turnover ratio of a mutual fund is measured as a percentage of the fund’s holdings that have been sold and replaced during the prior year.

For example, if a mutual fund invests in 100 stocks and 50 of them are replaced, the fund would have a turnover ratio of 50 percent. The average actively managed fund has a turnover ratio of nearly 90 percent.

Because the fund’s holding period was less than one year, this could result in a lot of short-term capital gains being distributed to the investor each year. This is true even if the fund loses value.

In the current tax environment, that means those short-term capital gains can be taxed at a rate as high as 43.4 percent.

See also: The dangerous lie Dave Ramsey tells about cash value life insurance

wealth management

5. Consider the benefits of tax deferral and asset allocation

Just because an investment may have a high turnover ratio or high tax drag doesn’t mean it’s not a good investment. It might be a great investment. The question is, where do you want to own it? That is the art of asset allocation.

The standard advice has been that investments that throw off income taxed at the ordinary income rate belong in tax deferred accounts where investments taxed at more favorable long-term rates belong in taxable accounts. Assets located in taxable accounts could include tax managed mutual funds, index funds, ETFs, funds with lower turnover ratios and lower tax drag and municipal bonds, whereas higher returning and less tax efficient investments should be held in tax deferred accounts. Those assets could include actively managed funds, tactical funds, funds with higher turnover and high tax drag, REITs, high yield bond funds and alternatives.

When thinking of the benefits of tax deferral think of the “Rule of 72.” A tax deferred account growing at an annual rate of 7.2 percent will double in 10 years. It will take a taxable account, at a 25 percent tax rate, 14 years to double or 40 percent longer. At the highest tax bracket, it will take 17 years or 70 percent longer.


6. Tax diversification:

Many taxpayers will have no idea what the tax environment will look like when they decide to retire. And because they have no idea, it may make sense to begin to tax diversify their retirement portfolio by creating different investment buckets:

    • a taxable bucket for their stocks, real estate and tax efficient mutual funds;

    • a tax deferred bucket such as IRAs, 401(k) plans and non-qualified annuities;

    • and a tax free bucket such as municipal bonds, Roth IRAs and life insurance.

(Taxpayers should keep in mind, however, that although municipal bonds are income tax free they can impact the taxation of Social Security benefits and may have Alternative Minimum Tax consequences.)

Having a tax diversified portfolio willgive the taxpayer greater control over the timing of their taxes, managing their tax brackets and their tax liability in retirement.

Tax diversification and product allocation may be just as important as investment diversification and asset allocation.

tax form

7. Review last year’s tax return.

Of course, investors cannot eliminate all investment-related taxes, but they can control them and improve a portfolio’s efficiency. To that end, your clients may want to ask themselves these questions:

    • Did I pay higher taxes on investment income last year?

    •  Was I subject to the 3.8 percent Medicare surtax?

    • Am I invested in high turnover mutual funds?

    • Am I invested in mutual funds with a high tax drag?

    • Did I receive a 1099 last year even though I didn’t sell the investment?

    • Did I pay taxes when rebalancing the asset allocation of my portfolio?

    • If the investments are for retirement, am I paying taxes on income that will be used in the future?

You and your client may also want to consider whether they had large numbers in the following lines of last year’s personal income tax return.

    • Line 8a: Taxable Interest

    • Line 9a: Ordinary Dividends

    • Line 13: Capital Gains

The benefits of tax efficiency, tax diversification and tax deferral become more compelling in a changing and potentially rising tax environment. When contemplating tax efficient investments, consideration may be given to the benefits of low cost, investment-only annuities.

These products allow investors better control over taxes, tax-free portfolio rebalancing and the ability to defer taxation on income until the income is actually needed. While traditionally thought of as a vehicle to protect high income clients, it is important to note that tax deferral benefits investors of all income levels. In fact, for lower to middle income taxpayers, deferring gains and income on assets can have ancillary benefits such as reducing clients’ Social Security taxes and health care costs.  

Rising taxes will have greater influence on investor behavior. Taxes erode portfolio returns. Tax diversification and product allocation will likely be as important as investment diversification and asset allocation in the future. Year-end is the perfect time to review strategies to reduce taxes and improve the tax efficiency of a client’s investment portfolio. 

See also:

The advisor opportunity in tax season 

5 overlooked tax deductions for small business owners

These are the top 5 trends shaping the annuity market


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