I’ve written extensively during the past year about investing in expensive markets. If you believe, as I do, that the next five years might produce lower returns, then managing frictional costs becomes even more important.
As we move toward the end of 2016, I thought I’d focus my efforts on some strategies you can employ to increase the tax efficiency in your portfolio.
Asset location: Where your assets are located (within taxable or tax deferred accounts) can be an important decision.
The basic idea is that those assets that are tax inefficient (they create taxable income or short-term capital gains) should be placed in tax-deferred accounts like IRA’s. Those assets that are more tax efficient (qualified dividend income, growth stocks) should be placed in non-qualified / taxable accounts.
By constructing your portfolios in such a fashion, you are able to avoid recognition of the more unfavorable tax treatment by sheltering and deferring those gains until taking a distribution from the qualified accounts. In their paper Alpha, Beta, and Now ... Gamma, David Blanchett and Paul Kaplan argue the benefit to a retiree could be as large as half a percent per year.
Some asset location decisions might not be as intuitive as we would hope. Most international stocks and American depositary receipts levy withholding taxes on dividends paid to U.S. investors. In a taxable account, these withholding taxes can be offset by the foreign dividend tax credit.
A tax deferred account can’t benefit from the dividend tax credit and therefore international securities are best held in taxable accounts. There are a few exclusions such as the United Kingdom and India, which do not levy withholding taxes and therefore could be held in either type of account.
Master limited partnership (MLP) cash distributions are not directly taxable. Instead, they reduce the investor’s cost basis for tax purposes. If MLP income allocations exceed an annual limit of $1,000, the account – not the investor – may owe tax at rates up to 35 percent.
This would require your IRA to file a tax form 990T with the tax due April 15. As such, MLP’s should be held in taxable accounts unless directed otherwise by your tax advisor.
Prioritization of the asset location decision largely rests on personal goals and objectives. Tax decisions shouldn’t drive investment decisions.
For example, fixed income or bonds are often associated with interest income that is taxed at ordinary rates. As such they are often considered best placed in a qualified account or IRA to shelter the income.
In today’s low-yield environment, it might be more impactful to place a higher growth vehicle into the IRA to provide greater long term benefits. By modeling out various goals and scenarios, you can make more informed decisions that can lead to better outcomes.
Tax loss harvesting: This is a popular tax planning strategy, especially as investors scramble at year’s end to accelerate deductions into the current year and postpone income recognition to the following year. The basic idea is to find a position in your non-qualified accounts that carries a loss. You sell the position to capture the loss to use against taxable income for the year. You must stay out of the position for 30 days before repurchasing or the IRS will disallow the deduction. Google search “IRS Wash Sale Rules” for the rules.
3.8 percent Medicare surtax: If your modified adjusted gross income exceeds $200,000 individually or $250,000 jointly, you should consider having a strategy in place to minimize your recognition of unearned income.
Charitable contributions: These allow an immediate deduction up to annual limitations. To maximize your tax advantages, consider utilizing appreciated securities or even required minimum distributions from your IRA if you are over 70 1/2 . Both will provide a better deduction and the charity can use their 501c3 status to avoid the gains on their end.
Advisory fees: I often see tax returns from new clients that don’t take a deduction for advisory fees. Expenses for investment advisory services are a miscellaneous deduction subject to the 2 percent limit. You cannot deduct advisory fees charged to an IRA or qualified account. Talk to your tax advisor about whether it makes sense to pay qualified advisory account fees from an outside account.
Gardner Sherrill, CFP, MBA, is an independent financial adviser with Sherrill Wealth Management. To learn more visit sherrillwealth.com.