In investing, when something sounds too good to be true, it generally is. Plenty of examples over the last three years show that speculating on supposed “risk-free returns” can instead result in “return-free risk.”
By Mat Neben, Vice President and Portfolio Manager, Whittier Trust
Despite these cautionary tales, investors still have a dependable option for increasing returns without adding material portfolio risk: tax planning.
The following examples show how an effective tax plan can improve investment results. Keep in mind that tax laws are complex and constantly changing. We recommend talking with a trusted tax professional before adopting any tax strategy.
Profiting from Your Losses
Stock markets are volatile. No one enjoys buying an asset that declines in price, but tax-conscious investors can turn that pain into an opportunity.
When you sell a stock that has appreciated, you realize gains and create a tax liability. The inverse is also true. Selling a stock that has declined can realize a tax loss and reduce your future taxes. This is commonly called “tax loss harvesting.”
If you actively harvest losses and stay fully invested through market downturns, price volatility can actually add to your overall wealth.
The higher your tax bracket, the more you gain from loss harvesting. On the other end of the spectrum, if a gap year or early retirement shifts you into a lower tax bracket, realizing capital gains might be beneficial. Accelerating the realization of gains into low-income years can reduce your future tax liability.
Location, Location, Location
Investment decisions should focus not only on what asset to buy but also on where to put it.
Equity mutual funds regularly distribute capital gains to their shareholders. These distributions are taxable to the investor, even if they did not sell any shares (and even if the fund had a negative return).
For employer-sponsored retirement accounts, where the tax inefficiency is irrelevant, equity mutual funds may be perfectly fine investments. But in taxable accounts, the distributed capital gains can turn a great fund into a poor investment.
Taxes and Hedge Funds
Absolute return hedge funds are designed to deliver positive returns regardless of market conditions. They are frequently held by some of the largest institutional investors. For example, at the end of the 2020 fiscal year, the $31 billion Yale Endowment had an allocation of 22% to absolute return strategies.
But what works for a tax-exempt endowment might not work for a taxable investor. Hedge fund returns are often fully taxable at your ordinary income rate. For investors in high tax states, this means that more than half the fund return may go to the government. If you are only keeping half of what Yale does for investing in the same fund, is the investment worth the added cost, complexity and potential illiquidity?
Hedge funds can still make sense for taxable investors. The strong risk-adjusted returns or diversification profile may more than compensate for the tax headwind. But it is important to focus on after-tax results and properly calibrate your expectations.
Don’t Pay the Penalty
If you sell a stock you owned for less than a year, the gain is taxed at your ordinary income rate. As discussed above, that rate can exceed 50% for high income investors in high tax states.
If you hold the stock for longer than a year, the gain is taxed at the long-term capital gains rate, which can be significantly lower.
The difference between your ordinary income rate and the preferential rate for long-term capital gains is the penalty you pay to place short-term trades. At top tax rates, short-term traders need to outperform long-term investors by more than 2% each year just to make up for the tax headwind.
By purchasing quality companies that you will own for at least a year, you align your investing with the tax code and avoid the punitive tax penalties facing short-term traders. Alternatively, high-turnover strategies can be located in a tax-exempt account, so gains compound tax-free.
Gifts and Inheritances
Stocks can be an incredible tool for long-term, tax-efficient wealth compounding. Dividend income is taxed at a preferential rate, and price gains are not taxed until the securities are sold.
One method to avoid realizing capital gains is to donate appreciated securities to a nonprofit. The nonprofit can sell the investment with little-to-no tax liability, and you can get a deduction for the full value of the security. If you are currently giving cash to charity, it is worthwhile to explore gifting appreciated assets instead.
Another method for managing deferred capital gains is to pass the asset on to your heirs. When you inherit an asset, its cost basis may be “stepped up” to match the market value as of the original owner’s death. The basis step up resets any deferred capital gains. While this rule might not be immediately actionable for most investors, it has significant portfolio management implications and can result in multi-generational tax savings.
The above topics are one small subset of potential tax planning strategies, and tax planning itself is just one aspect of a larger wealth plan. At Whittier Trust, we believe in a holistic approach to wealth management. We work with your existing advisors to develop comprehensive solutions for all aspects of wealth: investments, tax, estate plans, philanthropy and more.