As a new tax season has quickly come upon us, I’m using this quarterly commentary to take a look at some general investment tax thoughts vs. my usual market insight.
How often do you meet with your tax professional? Do you have a general idea where you stand before you meet to run the numbers? For many of us, filing our taxes is no more than a once-per-year retroactive accountability of the previous 12 months (if you’re punctual) and filled with anxiety, wonder and sometimes excitement. If that is the extent you are leveraging your tax professional, you need to listen up.
The beginning of the year is a great time to collaborate across the board with your accountant, investment professional and attorney. Take the opportunity to analyze your estate and investments for changes that should be made to possibly alleviate some of the tax bite for the coming year and to stay on top of any other tax or estate changes. I like to call this collaboration the “three-legged stool.” If one of the three lines of communication is missing, it can have lasting effects on your retirement and estate.
Investors underestimate the tax burden that inefficient investing can cause for their financial profile, especially those in a high tax bracket. You can start your analysis by looking at your investments and where you owe taxes for capital gains and dividends.
You really want to scrutinize the investments with consistent capital gains and nonqualified dividend distributions. Particularly, some growth portfolios have substantial turnover of the investments and may have a track record of distributing gains to the shareholders that are characterized short term.
The idea is to utilize your professionals to calculate your real rate of return net of taxes and then to compare your most tax-inefficient investments against an alternative such as a municipal bond. Surprisingly, you may find that you can take a lot of fluctuation out of your taxable investment portfolio and receive a very similar outcome by investing in something more tax-efficient.
Let’s use a hypothetical example assuming a taxable balanced portfolio that has realized since inception an average rate of return of 8 percent, half of which is consistently short term capital gains due to high portfolio turnover.
The portfolio may produce a tax-adjusted return of approximately 5.7 percent. To calculate what your real rate of return would be if you purchased a municipal bond, you would take the yield divided by one minus your tax bracket. If you are in a 35 percent tax bracket, and you purchased a municipal bond at par yielding 3.5 percent, you would have a tax-adjusted return of 5.38 percent. For some investors, the slightly extra return on investment might not be worth the extra risk in the portfolio.
The next time you find yourself accumulating information for your taxes, take the opportunity to leverage your accountant’s knowledge for the benefit of your investment portfolio. It may prove worthwhile to take a closer look at what you are retaining from each of your taxable investments and if it would be lucrative to place them in a retirement account or exchange it with a more tax-efficient investment.
Griffin Dalrymple, wealth manager for Opinicus Wealth Management, can be reached at (813) 872-7050.