It’s one thing to invest well and another thing to keep your profits, or at least as much as you legally can. One regularly scheduled event which can have a diminishing effect on returns is tax time. Whether or not you’ve made it through this year’s tax crucible unscathed, you need to be thinking now about how your investments will be taxed next year.
I’ve said this before, but many wealth managers are not investment experts. To this I’d like to add, even if they are financial experts, they are not likely to also be tax code experts.
Is your advisor grasping every opportunity to not only make you money, but help you keep what you have? I certainly hope so.
One of the things you should expect from your advisor is guidance on effective tax management of your investment accounts.
In general this means your advisor should understand your comprehensive situation and when additional taxes may be applicable so that your portfolios are constructed on a tax efficient basis to avoid (if possible) paying out more than you need to via the Alternative Minimum Tax, 3.8% Net Investment Income Tax, and/or higher taxes (20% versus 15%) on qualified dividends and long-term capital gains.
Specifically, it also means that your advisor should be continually monitoring your unique situation vis a vis tax implications. These might include, for instance, the tax implications of being self-employed, the impact of any privately owned businesses/investments that flow through taxation and the impact of various stock options including non-qualified stock options, incentive stock options and the sale of employee stock purchase plan shares.
Now a quick caveat — tax management does not necessarily mean not paying taxes.
Ironically, many investors, left to their own devices, try to save on taxes by moving large amounts into tax efficient investments which can lead to dangerously concentrated positions rather than diversifying and paying taxes.
You should expect your advisor to keep you from making bad tax-driven decisions but also pro-actively structure your account with your tax situation in mind.
One of the most common ways to mitigate taxes is tax loss harvesting, a method of limiting the recognition of short-term capital gains (which are typically taxed at a higher federal income tax rate). To capture the benefit, you sell a security that has lost value since you purchased it. Then, because of the wash-sale rule, you can immediately invest in a second security that is in the same sector as the first, or wait approximately a month before you repurchase the original stock.
Does your advisor have a good sense of you tax liability? If you’ve had significant gains, you may want to see if there are any loss positions that can be realized to mitigate the gain.
Any such moves have to be done well before the end of the tax year. If you have capital losses in excess of capital gains, the IRS allows you to use up to $3,000 of those excess losses per year to offset other income (wages, investment income, etc.) with the balance carried forward to offset gains in futures years.
Truly effective tax loss harvesting is harder than it looks. If your tax return filing covers more than one taxable account, for instance, all of those must be considered together, not separately, to comply with certain IRS rules.
How are dividends being handled? If you are not fully exiting the investment, any dividends that are reinvested, in the original investment would violate the wash sale rule.
Furthermore, any tax loss harvested has to be balanced against the transaction costs of buying and selling the securities in question.
And there are other ways to minimize taxes, all depending on your unique situation. If you’ve had a low-income year, you may want to take the opportunity to do Roth IRA conversions and convert income that would have been taxed at 25% or higher to 15% or lower. Keep in mind that the converted amount is generally subject to income taxation.
Similarly, your advisor should be looking ahead with you on optimizing your social security timing. Delaying taking benefits can have significant tax advantages since 85% of Social Security is taxable when there is significant other income.
Finally, the tax laws change all the time. It is not unreasonable to expect your advisor to have, or have access to, deep knowledge of tax code quirks and obscure provisions.
This information is not intended as specific advice for any individual since every person’s situation is unique. If your financial advisor does not have the knowledge to handle your tax situation, please consult with a tax advisor.