Monday, January 19, 2015

10 Ways to Tax Proof Your Portfolio

Charles Sizemore for writes: We just started the new year, and it’s already time to start thinking about taxes. W2 forms will start arriving within the next few weeks…followed by 1099s, K1s, and 1098 mortgage interest forms. For the next four months, all things related to federal income taxes will hang around your neck like an albatross.
At this point, there’s not a lot you can do to lower your tax bill or boost your refund, other than perhaps topping up your IRA or HSA account. What’s done is done for tax year 2014. But it’s still early enough in 2015 to get your affairs in order so that this time next year you’ll have a smaller tax bill to look forward to.
Let’s take a look at some common-sense moves to make to tax proof your portfolio.
1. Dump high-turnover mutual funds. Mutual funds that constantly buy and sell stocks create taxable gains that get pass on to you, the investor.
Don’t worry, this is not a tirade against actively-managed funds. While low-cost index funds have outperformed most active managers in recent years, there is still room in your portfolio for an active manager that adds value.  Even better if that active manager’s fund tends to zig when the market zags. But my advice here would be to avoid “closet indexers,” or mutual funds whose performance very closely tracks that of the S&P 500 but with higher turnover. Or at the very least, hold those kinds of funds in a tax-deferred account like a 401k plan or IRA.
2. Here’s a no brainer: Max out your 401k plan or come as close as possible. Every dollar of savings in a 401k plan is a dollar not subject to taxes. So assuming you have enough cash on hand for emergencies, you should plow every free dollar of savings into the 401k. In 2015, you can contribute $18,000, not including employer matching, and $24,000 if you are aged 50 or over. If you’re in the 35% tax bracket, you’re looking at tax savings of $6,300 to $8,400.
Not everyone has the financial flexibility to forgo $18,000-$24,000 in paycheck income. But if you can make it work, it’s in your best interests to do so.
3. Along the same lines, consider an IRA or Roth IRA if you income allows it. The contribution limit for both in 2015 is $5,500 or $6,500 for those 50 and older. You will get no tax break for a contribution to a Roth IRA, but at least you won’t be paying taxes on any dividends, interest, or capital gains earned on your investments. Roth IRAs—unlike 401k plans and traditional IRAs—also have no required minimum distributions. So, after age 70 ½, you won’t be forced to take money out and generate taxable gains in the process. Roth IRAs give you a lower potential tax footprint down the road.
For individual taxpayers, your ability to contribute to a Roth IRA starts to get phased out at the $116,000 level. For married couples filing jointly it’s $183,000.
If you’re looking for an immediate tax break, the traditional IRA is the way to go. But if you are covered by a retirement plan at work—such as a 401k plan—your ability to deduct your contribution starts to get phased out at $61,000 for individuals and $98,000 for married couples filing jointly.
4. If your health insurance plan offers the ability to contribute to a Health Savings Account (“HSA”), go for it. In 2015, the contribution limits for single taxpayers and family plans are $3,350 and $6,650, respectively. And if you’re aged 50 or over, you can tack on another $1,000.
There is a lot of misunderstandings about HSAs. To start, unlike some similar health plan, there are no “use it or lose it” provisions. Excess funds above and beyond what you need for current out-of-pocket medical expenses can be kept as cash or often times invested in mutual funds. If you change jobs and your new insurance plan is not compatible with an HSA account, no worries. Your existing funds are safe. In a lot of ways, HSAs are not too different from IRAs, with the big exception that HSAs come with a debit card for use at the doctor’s office.
If you’ve already maxed out your 401k plan and any IRAs you might qualify more, you can use your HSA as an additional tax-deferred investment vehicle.
5. Take advantage of your company’s deferred compensation plan if they offer it. Under a deferred comp plan, your employer diverts part of your pay into a tax-deferred variable annuity. Unlike 401k plans, which are pretty ubiquitous these days, not all companies offer deferred comp plans. And even if they do, they only make sense if you’re already maxing out your 401k. If your salary is high enough to allow you to max out your 401k at today’s higher levels, a deferred comp plan is the next obvious step.  Deferred comp plans will vary from company to company, but typically your employer will divert a portion of your pay to a variable annuity, where the funds can be invested in underlying subaccounts. You’ll pay taxes when you pull your funds out, but they can grow and compound tax free for years or even decades.
6. If you want to help a child or grandchild save for college, an Educational Savings Account (“ESA”) or 529 plan are the most tax efficient options. As is the case with Roth IRAs, there is no tax break for contributions, at least at the federal level. But your dividends, interest and capital gains can compound tax free. If your child or grandchild uses the funds for qualified college expenses, the withdrawals are tax free.
ESAs have very modest contribution limits—$2,000 per account per year—though 529 plans allow for much larger contributions. There is really no practical limit on most 529 plans, though any contribution by a single taxpayer over $14,000 would be subject to gift taxes in 2015. Still, a married couple could contribute a combined $28,000 with no tax consequences.
7. Giving to charity is a noble endeavor. But it pays to be smart about how you do it. Selling stock to generate cash for a gift to charity is a horrendously inefficient tax move. Yes, you might get a tax break for the gift itself. But you’ll be paying taxes on the capital gains.
A better move is to gift the stock itself. As a tax exempt entity, the charity can sell the stock and pay no capital gains taxes.
Think of it like this: Every dollar you avoid in taxes by using a strategy like this is an additional dollar you have available to give to charity. I don’t know about you, but I’d rather give that dollar to a cause I care about than to a wasteful government.
8. Move your assets around so as to make your portfolio as tax efficient as possible. For example, index funds generate very little in taxable income. Dividends received are often qualified and thus taxed at a lower rate. And capital gains are very infrequent. These sorts of funds should be held in a taxable account. At the other end of the spectrum, bond interest is fully taxable at your marginal tax rate, and collectibles are taxed at a special 28% tax rate. Tax inefficient investments like these should be held in IRA or 401k accounts to the extent you can.
9. Don’t forget about capital losses from prior years. We all hate losing money, but if you do have an investment that goes bust on you, you might as well use the tax write off. With the S&P 500 near all-time highs and the last bear market a distant memory, you probably have fewer saved-up capital losses than you might have had a few years ago. But if you sold any oil and gas investments recently, you may have some fresh losses to put to work. You can only write off net $3,000 in capital losses per year. So, if you manage your portfolio in a tax efficient way, one bad loss might last you several years.
10. And finally, I’ll give you a little trading advice. Tax avoidance should never be your primary motive in timing an investment sale. I can’t tell you how many times I’ve seen someone hold on to a stock for an extra month or two in order to qualify for long-term capital gains…only to see those gains evaporate as the price cratered. It doesn’t matter if you are value investor, a momentum investor or anything in between: When your investment methodology tells you to sell, you need to sell. I’d prefer to pay higher taxes on larger gains than no taxes on no gains.
That said, you sometimes have to do selling for other reasons, such as rebalancing or generating cash for living expenses. In these cases, it might pay to watch the calendar. To the extent you can, try to hold on to your investments for at least a full calendar year in order to benefit from the lower capital gains rate, which is 15% or 20% depending on your tax bracket.
Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.


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