Executive summary:
- There are several tax "traps" that can drag down a taxable investor's returns if they aren't aware of them
- These traps can result in higher tax costs on an investment portfolio
- We believe the best way to mitigate the impact of these changes is to plan for them
- Advisors who are aware of them may be able to help clients avoid them – potentially leading to greater after-tax returns
There is nothing like stepping into a trap to ruin a good golf game. Golfers like to hit the links for sport, camaraderie, and exercise, but they also want to get a good score. Even non-golfers can understand how swinging your way out of the sand trap can affect your final tally.
Investing taxable dollars without considering proper tax management can cause you to step into traps too: traps that create a cost that can hurt a portfolio's value. That cost is also known as "tax drag". There's nothing like sending hard-earned investment dollars to the Internal Revenue Service to ruin your day (or week or month or year) and set a portfolio back. Unfortunately, that happens to many investors, and it happens often. As an advisor, you can help your clients avoid these tax traps. But first you need to be aware of them:
1. Capital gain distributions: Navigating their impact in any market environment
Investors actively seek capital gains from their investments. Investors generally want to increase their wealth, which means that growing their capital is key. But capital gains can represent a tax "trap." When capital gains are realized, taxable investors will be taxed on them. It's therefore important to help your clients minimize realized gains and instead focus on growing their total wealth through unrealized capital gains.
The thing is, realized capital gains in securities portfolios or capital gain distributions from mutual funds are likely every year. Even in down years. Many investors assume that negative returns mean no taxes will be due. The reality is quite different. Take a year like 2008 – the worst market environment in several generations. Capital gain distributions in 2008 from U.S. equity mutual funds averaged 8% of Net Asset Value (NAV). In 2015 and 2018, also market drawdown years, we saw average distributions of 11% and 7% respectively. Let's just say tax pain can happen in any year; we feel it's best to minimize it by embracing a tax-managed approach to investing.
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2. Tax-loss harvesting: A year-round opportunity
There are two main ways to minimize taxes on capital gains: 1) defer capital gain realization far into the future and 2) find an "offset" for a realized capital gain.
This is where tax loss harvesting comes into play. Tax loss harvesting is a way to create an offset for a realized capital gain. Optimally, these offsets can be created by taking advantage of market movements (some will call this volatility) as they occur. Too often investors and their financial advisors, instead of harvesting losses opportunistically throughout the year, wait until the very end of the year to perform this crucial activity. While markets tend to follow a random walk, there appears to be a seasonal pattern. Markets have historically tended to do well in the last two months of the year, which are when many investors are harvesting losses. That may make it more difficult to find loss-harvesting opportunities. Avoid this trap by conducting tax loss harvesting throughout the year.
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Source: FactSet, Morningstar Direct. As of 12/31/2023. U.S. Equity: S&P 500® Index. For months from January 1950 through January 1988, used price returns. February 1988 forward, used total returns. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.
3. The cash tax trap: Watch out for the tax bite on interest income
Let's keep this topic short and sweet:
- Interest is taxable
- The impact of inflation is real
The return from a cash or cash-equivalent deposit is much less than most investors expect once taxes and inflation are factored in. Investors are often attracted to the pre-tax and pre-inflation interest rate…. but the post-tax and after-inflation return is another matter altogether. Those factors are important. Look at the numbers below to see what happens when taxes and different inflation environments are taken into account.
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CDs offer a fixed rate of return, and the interest and principal on CDs will generally be insured by the FDIC up to $250,000. Municipal bond fund investing is subject to the risks associated with debt securities including, but not limited to, credit, liquidity and interest rate risks. It may be adversely impacted by economic conditions, market fluctuation, and regulatory changes. * Based on maximum tax rate of 40.8% for Married Filing Jointly, including 3.8% Net Investment Income Tax. ** Income from municipal bonds may be subject to state or local income taxes and/or the federal alternative minimum tax.
4. Tax increases may be on the horizon
We have been blessed with a relatively low tax regime for an extended period. Some might not agree with that assessment, but the reality is that since the mid 1980s, tax rates on income and capital gains have been at a low level compared to history.
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What does the future hold? Well, in the intermediate term (next 1-8 years or so) we may well continue to enjoy this lower tax-rate party (all dependent on what happens next year with Tax Trap #5 ). But the longer-term outlook is a bit murky. Both the budget deficit and the federal debt level as a percentage of gross domestic product (GDP), are at very high and rising levels. It's hard for federal administrations to reduce government spending because most of the federal budget today is focused on entitlements, benefits, and interest payments based on the Congressional Budget Office's (CBO) analysis. That means taxes could go up in the future to bring down the deficit and government debt levels. Be aware of that possibility, and plan now.
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5. Tax Cuts and Jobs Act (TCJA): Only two tax filings left before it sunsets
Like the "Use by date" on a carton of milk, the 2017 Tax Cuts and Jobs Act comes to an end on December 31, 2025. Almost all the provisions will have expired by that point, potentially resulting in higher taxes for many taxpayers. It's crucial to be prepared.
What do you do now?
Being a tax aware advisor and embracing tax management is a year-long strategic endeavor.
When market conditions may be challenging, that's also when they present attractive opportunities to actively manage taxes in a portfolio. Volatility allows for tax-loss harvesting, which creates tax "assets" that can be used to offset future capital gains taxes.
Here are some steps you can take to help your clients:
1-Create a list of all of their mutual fund investments, the Net Asset Value (NAV) when they were purchased, and the current NAV.
2-Calculate the unrealized gains/losses, then sort the list by unrealized gains/losses.
3-Review investments that may be suitable for transition, in particular:
- Investments with losses represent an opportunity to create a tax asset to offset against other gains.
- Investments with close to zero unrealized gains/losses.
Arm your clients with the tools and resources to make sense of the tax cost of different investment options. And give strong consideration to what you use and how in your investment choices. Not everything is created equal when it comes to investments and taxes. Help your clients choose wisely!