And the 2010 Affordable Care Act (ACA) added a 3.8% Medicare surtax on the net investment income of those high-earning taxpayers. And that tax, which includes income from interest, rents, dividends and more, can increase the total tax rate to as much as 23.8% for long-term capital gains and 43.4% for ordinary income.
Given those changes, tax-aware investing is more important than ever before, say Robert Keebler and Peter Melcher, both partners with Keebler & Associates, and the co-authors of "Increased Tax Rates and Investment Strategy," an article just published in Investments & Wealth Monitor.
No. 1: If you're affected by ATRA and ACA, increase investment in tax-favored assets.
Tax-favored assets produce tax-exempt income, are taxed at lower rates, or defer taxes. For example, if you've invested in taxable corporate bonds, you could switch to tax-exempt municipal bonds.
And in the wake of ATRA, Keebler and Melcher say there is no tax rate advantage to growth stocks over dividend-paying stocks. Most dividends — that is, qualified dividends — continue to be taxed at the same rate as capital gains (20% at the highest marginal income tax rate) instead of at ordinary income rates (39.6% at the highest marginal income tax rate) following ATRA, and stock gains and dividends are both subject to the net investment income tax, Melcher says. On the other hand, the capital gains can be deferred while the dividend income can't.
So, high-income investors might want to look at how their interest income is taxed vs. capital gains. Interest income is taxed at 43.4%, while capital gains on stock sales are taxed at 23.8%. In other words, stocks retain a higher percentage of their return after tax — 76.2% vs. 56.6%. And this makes stocks a more tax-efficient investment, say Keebler and Melcher.
As for assets that produce greater tax-deferral, Keebler and Melcher recommend tax-efficient mutual funds, which are managed to minimize capital gains and dividend distributions. You might also consider index funds, which typically do little trading, and often pay little in capital gains distributions. And exchange-traded funds don't have to sell securities to meet investor redemptions, and also have low capital gains distributions.
Consider, too, using buy-and-hold strategies for your investments. Generally, say Keebler and Melcher, the lower a portfolio's turnover ratio, the greater the after-tax returns will be.
To be fair, total turnover may not be the best measure of tax efficiency. What counts, say Keebler and Melcher, is net turnover — capital gains that can't be offset with capital losses.
Remember, when contemplating these tactics, the goal is not to minimize taxes but to maximize after-tax return, say Keebler and Melcher. You shouldn't let tax considerations drive your entire investment strategy.
No. 2: Manage gains and losses from year to year.
If you want to save 19.6% on your tax bill consider holding your assets to take advantage of long-term capital gain rates — for at least one year and one day. Long-term capital gains are taxed at a maximum capital gains rate of 23.8%, while short-term capital gains are taxed at ordinary income tax rates, up to 43.4%, including the Medicare surtax.
If you've made many purchases over time, you can use the last-in, first-out method to account for gains in stock sales. It means that when you sell part of your holdings, you assume that you're selling the shares you've held the longest. Once you choose this method, which works best when stocks are rising, you can't switch.
You can also reduce your tax bill by selling your losing stocks, Keebler and Melcher say. Let's say it's December and you face a big tax bill from assets sold at a gain during the year. To avoid this bill, you would sell enough assets with capital losses to net out the capital gains, or at least to reduce them. Be sure to wait 31 days before buying back the stock sold at a loss. Otherwise, the IRS will deem the sale a wash sale, and you won't be able to claim the loss.
Two notes of caution when using loss harvesting. One, you'll bear the risk that the stock price will rise during the 31 days you are out of the market. And two, it's better to harvest gains when rates are low and harvest capital losses while rates are high.
No. 3: Carefully construct your portfolio.
Building a portfolio that maximizes after-tax returns vs. one that maximizes pre-tax returns is not the same.
Keebler and Melcher say investors should allocate their assets among stocks, bonds and cash with an eye toward trimming tax bills. "In tax-aware investing, asset allocation is done in the usual manner, except that after-tax values are used for the assets instead of pre-tax values," say Keebler and Melcher.
No. 4: Manage asset location.
Once you decide how to allocate your assets, you'll have to decide how to distribute those assets across taxable accounts, tax-deferred accounts, and tax-exempt accounts to minimize total taxes. To do this, you'll have to rank the tax efficiency of each asset in the portfolio. Junk bonds, for instance, tend to be the least tax-efficient assets, while tax-exempt municipal bonds tend to be the most tax efficient.
Next, you would put your least tax-efficient assets in your tax-exempt and tax-deferred accounts. And then you would put all remaining assets into taxable accounts.
No. 5: One last note.
If you have your doubts about tax-aware portfolios, consider this: Tax-aware portfolios generate on average 2 percentage points more in returns than portfolios that ignore taxes, say Keebler and Melcher. And that means more for you and less for Uncle Sam.
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