Everyday tips to help manage taxable portfolios

We’re right up against the conclusion of the 2014 tax season, but there are still plenty of tax-aware ideas that can serve you and your clients wellthroughout the year. It’s not always easy, but working towards higher after-tax returns is worth it for tax-sensitive investors. Here are four tips I recently discussed in a short video series.
  1. It would be easier if you could buy and hold forever, but you likely have to sell at least some of your securities at some point. Pay attention to holding periods.
We talk a lot about the importance of having a long-term perspective at Russell, and this is especially relevant when considering the holding period of a security. When it comes to a tax-managed approach, the difference between a long-term and a short-term capital gain is huge. Today, for example, long-term capital gains are taxed at 23.8% at the marginal federal tax level. But short-term capital gains are taxed at a whopping 43.4%. That’s a significant difference. However, this is one outcome that is easily within your control. How the law defines a long-term versus a short-term holding period is 366 days or more and 365 days or less, respectively. So one day can make a really big difference in the potential tax liability your client may experience.
  1. Avoid wash sales.
A wash sale is when you sell a security at a loss and then buy it – or a substantially similar security – back in 30 days or less. Doing this could generate a wash sale, which may either defer or sacrifice a loss in the client’s portfolio. It’s relatively easy to avoid a wash sale. You just have to be sure and wait 31 days or longer to buy back that same, or a substantially similar, security you sold at a loss. Holding onto that loss is important because losses can be used as an effective tool to offset potential gains in a taxable portfolio.
  1. It would be easier if you only had gains to manage, but markets move. Harvest losses when appropriate.
We’ve established that losses can represent an important lever in taxable portfolio. Harvesting those losses can be a very effective strategy that may allow a manager or advisor to essentially harvest market volatility. While the market and individual securities are moving up and down, there are often potential opportunities for managing – and potentially minimizing – the tax liability in a portfolio. It all comes down to managing the data of your client’s holdings, tax lots and trades to possibly control the exposures in a portfolio. When done well, harvesting losses could potentially lead to a better after-tax outcome for your clients.
  1. It would be easier if all investment income was tax free, but that’s not the case for appropriate clients. Lean toward non-taxable interest and qualified dividends.
Investment income can often play an important role in the total-return of a portfolio. But in a taxable portfolio, it can pay to be aware of the tax implications associated with that income. Income is typically generated by interest and dividends. On the fixed income side, bonds pay interest that in most cases is taxed as ordinary income. Now if a client is in the highest federal income tax bracket that equates to 43.4%. That’s a lot of potential return to give up to taxes. But many municipal bondshave a zero percent tax rate, which means the income they generate is non-taxable. So this becomes an important consideration -- especially for high earners. On the equity side, there are two kinds of dividends. For appropriate investors, you may want to consider focusing on qualified dividends because they’re the more attractive tax option in a tax-aware portfolio. Qualified dividends are taxed at 23.8%. That’s far more attractive than 43.4% and that’s why each different source of income needs to be considered carefully. At Russell, we believe non-taxable interest and qualified dividends offer investors a more tax-efficient way to generate income for a taxable portfolio.

The bottom line

When you keep these kinds of ideas in mind and take a tax-aware approach, we think your clients could stand a good chance of achieving a better after-tax return. And that’s really what it’s all about.