Three Tips to Temper Taxes
Oct. 6, 2021
Calming concerns about potential tax increases can be challenging when the details remain unclear. So how can you deal with their worries during this time of uncertainty? Focus on what you can control today.
What You Can Do Now
Investing with an eye on taxes is an ongoing effort. It’s important to regularly review specific situations and long-term goals and be on the lookout for opportunities to take advantage of important tax-mitigating moves throughout the year.
Consider three strategies that may improve the overall tax efficiency of your clients’ portfolios, regardless of prevailing tax rates.
Harvest Tax Losses - In some cases, you may be able to turn investment losses into strategic wins for your clients. Using losses to offset gains may result in a lower tax bill.
Manage Capital Gains and Dividends - Managing capital gains and dividend distributions, from holding periods to ex-dividend dates, can potentially help enhance a portfolio’s tax efficiency.
Plan Investments Strategically - Focusing on tax-friendly investments—and implementing strategies and tactics designed to reduce the portfolio’s tax liability—helps keep tax efficiency at the forefront all year long.
Harvest Tax Losses
While losses are never the goal, losing money in an investment can sometimes have an upside. With a tax-loss harvesting strategy, investment losses in one or more investments can help offset gains in others, which may result in a lower overall tax liability. Investors can use their realized losses to offset capital gains or ordinary income, up to $3,000 in a single year for joint filers ($1,500 for single filers), according to the Internal Revenue Service (IRS). Investors may carry forward any additional losses indefinitely. Figure 1 provides a hypothetical example of how the strategy works.
Figure 1 | Tax-Loss Harvesting: A Hypothetical Example
This hypothetical situation contains assumptions that are intended for illustrative purposes only and are not representative of the performance of any security. There is no assurance similar results can be achieved, and this information should not be relied upon as a specific recommendation to buy or sell securities.
The hypothetical long-term loss from the sale of XYZ partially offsets the long-term gain from the sale of ABC.
This example assumes a capital gains tax rate of 15%. This rate varies by filing status and income.
The offsetting loss results in a tax savings of $600.
When using the tax-loss harvesting strategy, it’s important to keep a few things in mind:
Be mindful of the wash sale rule. This IRS rule prohibits the purchase of the same or “substantially identical” security within 30 days (before or after) of selling that security at a loss. You also may not sell a security at a loss in a taxable account and purchase that same security for a tax-deferred account within 30 days of the sale. However, you may purchase a similar investment to maintain exposure to that industry or sector.
Know your alternatives. Consider the relative advantages and disadvantages of using ETFs, active mutual funds or indexed mutual funds to replace a security sold at a loss.
Don’t let taxes alone drive the sell decision. Before harvesting tax losses, make sure the sale makes sense for the overall investment strategy and client goals.
Use for taxable accounts only. There’s no benefit to harvesting losses in a tax-deferred account.
Manage Capital Gains and Dividends
Monitoring distribution timelines and investment holding periods—and determining if or when to buy or sell specific assets—are important components of a comprehensive investment strategy. These planning efforts can make a big difference in the portfolio’s yearly tax bill.
Regarding capital gains, the holding period is crucial. How long your client owns an investment before selling it at a profit will determine the tax liability. Selling an investment owned for less than one year triggers a short-term capital gain, while exiting an asset owned for more than a year causes a long-term capital gain.
In general, long-term capital gains receive more favorable tax treatment than short-term gains, which are taxed as ordinary income at marginal rates as high as 37%. The maximum tax rate for long-term capital gains is 20% (see Figure 2).
Figure 2 | Long-Term Gains Get Favorable Tax Treatment
Long-Term Capital Annual Inc Married Filing Jt Annual Inc Single Taxpayer
Gains Tax Rate
0% $0 to $80,000 $0 to $40,000
15% $80,001 to $496,600 $40,001 to $441,450
20% More than $496,600 More than $441,450
Similarly, dividends receive different tax treatment depending on their classification. Qualified dividends are taxed at the same rates as long-term capital gains. Nonqualified dividends are treated as ordinary income for tax purposes, taxed at regular income tax rates of 10%, 12%, 22%, 24%, 32%, 35% or 37%. To be qualified, a dividend:
Must be paid by a U.S. corporation or qualified foreign entity.
Cannot consist of premiums or insurance kickbacks, annual distributions from a credit union or dividends from co-ops or tax-exempt organizations.
Must meet holding period requirements, which differ for each asset type.
There are other important dates and timelines to consider regarding capital gains and dividend distributions (see Figure 3). In most cases, given a two-day settlement period:
If you buy a security before the ex-dividend date, you will receive the dividend (or capital gains distribution).
If you buy a security on the ex-dividend date, you will not receive the dividend (or capital gains distribution).
If you sell a security prior to the ex-dividend date, you will not receive the dividend (or capital gains distribution).
If you sell a security on the ex-dividend date, you will receive the dividend (or capital gains distribution).
Figure 3 | Know Your Distribution Timeline
Sell/Buy Date Ex-Dividend Date Record Date
↓ ↓ ↓ ↓ ↓
Monday Tuesday Wednesday Thursday Friday
5th 6th 7th 8th 9th
Plan Investments Strategically
Over time, the effect of capital gains distributions can add up, cutting into your client’s long-term profits. Consider these figures for a hypothetical $100,000 investment in the average U.S. large-cap stock mutual fund, according to Morningstar. For the period 2010 through 2019:
Assuming an average annual return of 12%, the portfolio’s pretax value at the end of the10-year period was nearly $311,000.1
The average annual tax cost for the period was 1.77% or $1,770—nearly twice the average expense ratio of 0.91%.2
The total tax bill for the 10-year holding period was approximately $46,000, cutting the after-tax portfolio value to $265,000.1
Figure 4 | The Effect of Capital Gains Distributions
Limiting the effect of taxes on a portfolio’s long-term performance requires ongoing attention to the portfolio’s holdings. Perhaps most importantly, consider constructing the portfolio with tax-efficient investments, such as ETFs.
Tax Efficiency of Mutual Funds vs. ETFs
Compared with actively managed mutual funds, many ETFs experience lower turnover—and therefore, fewer taxable events. In addition, the ETF structure is generally more tax friendly than most mutual funds.
When mutual fund investors redeem shares, the fund may have to sell securities to meet the redemptions. And those sales may trigger capital gains for the fund and all its shareholders. But when ETF investors sell shares, they sell those shares to other investors, resulting in no taxable gains for the ETF.
In addition to using tax-efficient investments to create a solid foundation in the portfolio, implementing other tactics may help limit the annual tax bill:
Pursue a buy-and-hold strategy to reduce turnover within the portfolio.
Limit exposure to investments that pay taxable distributions several times a year.
Minimize long-term gains.
Avoid taking short-term capital gains, which are typically taxed at a higher rate.
Invest regularly, rather than trying to time the market.
Target Tax Efficiency All Year Long
Taxes shouldn’t drive your clients’ investment decisions, but tax consequences should be an ongoing consideration. For example, remain mindful of the potential liability associated with the investments in your clients’ portfolios. Also, think strategically about purchases and sales, ensuring all transactions make sense from a tax perspective. And make tax planning an ongoing effort, so tax season doesn’t reveal any tax-bill surprises.
1 American Century Investments calculations are for illustrative purposes only and are not indicative of the performance of any fund or investment portfolio. The calculations do not include commissions, sales charges or fees.
2 Source: Morningstar, as of December 31, 2019. The tax rate applies to the oldest share class of all active U.S. large-cap equity open-end mutual funds available in the U.S.
This material is for informational purposes only. Neither APFS nor its Representatives provide tax, legal or accounting advice. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purposes of avoiding penalties that may be imposed by law. Each tax payer should seek tax, lega
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