Chad Smith for Investment News writes: Thanks to strong equity market returns over the past two years,
investors have made significant progress in rebuilding their portfolios.
Many clients, however, remain on edge as they wait for the “other shoe”
to drop. Contrary to the first-blush reaction of many, this other shoe
isn't the potential of continued gridlock in future months around our
nation's debt ceiling — it's the impact of an ever-more-complex tax
code.
Last January, the top capital gains tax rate increased from
15% to 20%, while a 3.8% investment income surtax kicked in for many
investors as well. Those are just the federal taxes — depending on
where they live, many clients are preparing themselves for another
significant tax hit at the state level as well.
More than ever
before, financial advisers possessing or having ready access to
professional tax expertise can add value for their clients. This unique
quality allows advisers to distinguish themselves by providing guidance
that integrates both tax and investment solutions. For one clear example
of this, look no further than the basic practice of tax loss
harvesting.
No doubt, the vast majority of advisers understand the concept that
investors should look to sell the losers in their portfolio at the end
of the year in order to offset gains from winners. In 2013, as many
investors' portfolios have shifted away from their asset allocation
targets due to gains in equity assets and losses in fixed income,
harvesting losses in a careful and strategic manner will be especially
crucial.
Without access to tax expertise, however, even this
fundamental practice can be difficult for advisers to implement.
Estimating capital gains and losses for every asset in each
non-qualified account, for each client, and then executing the proper
strategy to lock in the most favorable tax treatment is a time-consuming
and complex process. For both advisers and their clients, however, the
effort is clearly worth it: no investor can afford to lose out on tax
savings that may amount to 30% or more of their capital gains when state
and federal taxes are considered.
Capital gains are taxed
differently depending on the holding period of your investment. The
holding period is how long you have held an investment. A short-term
holding period is typically one year or less, and a long-term holding
period is usually more than one year.
Short-term capital gains
are taxed at ordinary income tax rates. In 2013, this ranged from 10% to
39.6%. The tax on long-term capital gains is typically less than
ordinary tax rates. The long-term capital gains tax is either zero
percent, 15% or 20% depending on your marginal tax bracket.
For
advisers seeking to maximize tax benefits for their clients by
harvesting losses in 2013, we suggest the following best practices:
1.
Look for opportunities to maintain each client's overall investment
strategy and asset allocation targets by substituting exchange-traded
funds or indexed funds with similar objectives and holdings for the
winners and losers being sold.
Advisers and clients often find
themselves stymied in executing tax loss harvesting plans because they
believe strongly in a given fund manager, or because selling a fund
would reduce the client's exposure to certain assets or sectors. By
shifting client assets into funds that are similar to those being sold,
advisers can continue to participate in managers' strategies, while
often maintaining very similar overall holdings.
In the ETF world,
substituting one ETF for another without disrupting a client's
strategies or asset allocations is even more straightforward.
2. Be aware of the wash sale rule, an Internal Revenue Service
rule that prohibits a taxpayer from claiming a loss on the sale or
trade of a security in a wash sale. The rule defines a wash sale as one
that occurs when an individual sells or trades a security at a loss and
within 30 days before or after this sale, buys a “substantially
identical” stock or security, or acquires a contract or option to do so.
A wash sale also results if an individual sells a security, and the
spouse or a company controlled by the individual buys a substantially
equivalent security.
In order to ensure that clients recognize
losses of the same magnitude as their gains and achieve the strongest
tax deferral outcomes in 2013, there is simply no substitute for a
manual review process performed by an attentive adviser. For investors
who will experience lower income next year, the right answer may be to
hold off on selling 2013 winners altogether.
3. For clients with
significant assets but whose income puts them in the 15% ordinary income
tax bracket (below $72,500 for married taxpayers filing jointly or
$36,250 for single filers), consider taking winners off the table even
if the client does not have offsetting losses elsewhere. Taxpayers in
the 15% bracket can sell appreciated stock at a 0% federal capital gains
rate. Selling now may be the best way for such investors to ensure they
benefit from the current tax treatment. Moreover, these clients can
establish a stepped-up basis in similar assets by shifting their
holdings from current winners into similar funds as mentioned above.
As
we're seeing more each year, the rising complexity of the tax code and
ongoing potential volatility in the capital markets are driving
investors — particularly in the high-net-worth segment — to recognize
the inherent value that comes from combining investment advice with
in-depth guidance on the tax front.
No matter how well a client's
investment strategy performs, no investor can afford to lose out on the
incremental returns that come from a properly-executed tax loss
harvesting process. By committing the time to implement the best
practices listed above, advisers can ensure that their clients are
well-positioned to weather changes to the tax code both this year and in
the future.
Friday, December 20, 2013
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