ORLANDO, FL (PRWEB) December 02, 2015
As Benjamin Franklin said, there are only two things certain in life—death and taxes. While both may be inevitable, the amount of taxes a person pays can still be in their control, especially when it comes to investment strategy. In part four of its five-part series on identifying common portfolio mistakes and resolving them, LAMCO Advisory Services (http://www.lamcoadvisory.com) examines the tax efficiency of portfolios and two methods for improving it.
Many are familiar with the concept of asset allocation, the process of dividing a portfolio amongst different strategies to provide diversification. A distant cousin of this strategy is asset location, which involves further dividing the portfolio to achieve tax efficiency.
In a well-designed asset location strategy, investments that are likely to create higher amounts of current taxable income (i.e. dividends, interest, short-term capital gains) might be considered for allocation into accounts that shield those earnings from taxes, such as traditional IRAs. Alternatively, investments that generate low amounts of taxable income or short-term gains would be best held in taxable accounts.
However, in the world of investments, there is no one-size-fits-all solution. As such, an asset location strategy cannot be universally applied to every portfolio. Items to take into consideration before attempting to construct an asset location strategy include:
- Whether you have to have the proper mix of accounts. For an Asset Allocation strategy to be effective, the investor needs the correct account types and the proper amount of assets within those account types.
- Whether you are in a higher marginal income tax bracket. The larger the spread between the investor’s ordinary income tax rate and their long-term capital gain rate, the more effective this strategy becomes.
- Whether you expect your tax rate (federal and/or state) will be lower when you retire and start to withdraw from an IRA.
- Whether you own, or intend to own, investments that will result in higher taxes today if owned in a taxable account.
Another technique to improve tax efficiency is tax loss harvesting. This is the process of selling a security at a loss to harvest the tax benefit that loss can provide. The proceeds from the sale are reinvested in a similar, but not identical replacement security to keep market exposure constant. That harvested loss has an economic benefit, as it can be used to offset future gains which would have otherwise been taxed. Further, because the proceeds from the sale were reinvested to maintain market exposure, the portfolio continues to participate in the market.
After 30 days have passed, if an investor wants to repurchase the security sold at a loss, they can sell the replacement security and repurchase the security sold at a loss. The higher their tax bracket, the more beneficial this strategy can be. For example, an investor who pays a 15% capital gain tax would effectively save $0.15 of tax for every dollar of future gain.
Despite the benefits, investors are often reluctant to employ a harvesting strategy. They have been preconditioned that you haven’t truly lost money on an investment until you sell the investment and lock in that loss. By its very nature, a harvesting strategy is locking in the loss. That is why reinvesting the proceeds from the sale in a highly correlated, but not identical security, is so important. It allows the investor to continue to participate in the market while they stay out of the sold security for the required 30-day period (see Wash Sale Rule below).
As in asset location, there are certain conditions to consider before employing a harvesting strategy.
Beware of the Wash Sale Rule. The IRS does not allow an investor to sell an asset solely for the purpose of paying less tax. For example, you couldn’t sell a stock on a Monday to recognize the loss and buy it back on Tuesday. The IRS indicates that the loss will be disallowed if the same or substantially identical security is purchased within 30 days from the date of the sale.
There could be an opportunity cost. Because the replacement security cannot be identical, its performance will differ from the security sold. If it underperforms over the 30-day period, that will diminish the effectiveness of the strategy. In tax harvesting, this is a risk that you assume; therefore, the investor should make sure the tax benefit is sizeable enough to warrant the risk.
Be careful in selecting the replacement security. As mentioned above, an investor’s portfolio cannot be so similar that it violates the Wash Sale Rule. However, it shouldn’t be so dissimilar that it performs substantially different than the security it replaced.
Depending on an investor’s unique situation, building a tax strategy around your investments could increase their portfolio’s efficiency. From asset location that takes the types of investments they own into account, to tax loss harvesting to maximize benefits, there’s bound to be a prudent strategy that could work.
To read LAMCO’s fourth installment in its entirety, please visit http://www.lamcoadvisory.com/insights/. For more information on identifying common mistakes investors make in their portfolios, and how to address them, be sure to also read through the first three installments of LAMCO Advisory Services’ five-part series.
*Disclaimer: This is for informational purposes only and does not constitute investment or tax advice.
About LAMCO Advisory Services, Inc.
Our history as financial stewards spans generations, but our focus has always remained on the most important piece of our proven process—our clients. LAMCO’s roots are firmly planted in helping our clients fulfill their objectives. Founded as a retirement plan consulting firm in 1974, by the mid 1980s, we began helping retirement plan fiduciaries fulfill their responsibilities through comprehensive, prudent plan and investment management.
In 1991, LAMCO Advisory Services, Inc. emerged as a committed partner for individuals seeking private wealth and investment consulting services. Today, as we have since our inception, we act as stewards of our clients’ objectives, ensuring our focus remains securely fixed on helping them achieve exactly what they want and need from their finances. For more information visit http://www.lamcoadvisory.com.
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