Most financial advisors, myself included, are not tax professionals. There are, however, numerous tax related investment strategies that can help maximize an investor’s after-tax returns. In this article, we’ll look at two of the most commonly used strategies where advisor awareness and prudence may assist in optimizing after-tax returns: tracking capital gains distributions and tax-loss harvesting.
TRACKING CAPITAL GAINS DISTRIBUTIONS.
Paying attention to capital gains distributions for funds held in taxable accounts is one way to enhance after-tax returns. Under the Investment Company Act of 1940, mutual fund companies must distribute all or substantially all of their net investment income from dividends, interest and realized capital gains to their shareholders each year in the form of capital gains distributions.
Many mutual funds carried forward losses from 2008 to offset several years of realized gains as the market rebounded. However, most funds have depleted their tax loss carry forwards and the topic has become salient again as capital gains distributions have increased in recent years.
Tracking capital gains distributions for funds held in taxable accounts enables investors to weigh the pros and cons of moving out of a fund before the record date to avoid a significant capital gains distribution. Similarly, investors should be cognizant of upcoming capital gains distributions for funds they are contemplating purchasing.
Such awareness positions investors to appropriately consider the pros and cons of buying a fund before or on the record date and becoming subject to taxes on gains experienced before they owned the fund.
While in an ideal world all asset classes would only appreciate, that’s not reality. Tax-loss harvesting enables an investor to make lemonade out of lemons by realizing losses to help offset gains in a taxable account; such action ultimately reduces the investor’s tax liability. If that investor realizes more losses than gains in one particular year, he or she can use up to $3,000 of losses to offset ordinary income and carry forward any remaining losses to future years.
Proper execution of tax-loss harvesting involves avoiding wash sales, which result from buying the same (or a substantially identical) security within 30 days before or after selling the security. Since some mutual fund companies have short-term trading policies that can be more restrictive than 30 days or impose additional fees, it’s also important that investors review the fund company prospectus.
To maintain their target asset allocation and avoid being without exposure during a potential market run, prudent investors will replace the security being sold with one with a high correlation.
Tax-loss harvesting enables an investor to make lemonade out of lemons.
For example, when our firm used the significant underperformance of commodities in 2015 as a tax-loss harvesting opportunity to offset gains in other areas of our portfolios, we replaced the actively managed commodity fund we sold out of with a passive commodities fund. This prevented a “wash sale,” yet kept portfolio risk and exposure consistent. This strategy helped us reduce our clients’ tax liabilities and, at the same time, ensure that they’d be positioned to take advantage of a recovery within commodities.
While proper tax strategies can enhance after-tax returns, it’s important to note that taxes are just one factor to consider when you’re investing. Having a well-thought-out financial plan, maintaining an appropriate asset allocation and keeping emotions and short-term reactions out of investing decisions are all critical moves for long-term investing success.
Working with an advisor who can implement the strategies outlined above, within the context of a broader financial plan, will help an investor realize the full benefits of tax-efficient investment management.
Financial representatives do not give, and this article is not intended as, legal or tax advice. All investments carry some level of risk, including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against loss. Naugatuck Financial is a marketing name for Justin Charise, Alfred Schor, and Colin Thomas and is not a broker-dealer, registered investment advisor, federal savings bank, subsidiary or other corporate affiliate of The Northwestern Mutual Life Insurance Company including its subsidiaries, nor is it a legal partnership or entity. Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM), and its subsidiaries. Charise, Schor, and Thomas are Representatives of Northwestern Mutual Wealth Management Company®, NMWMC Milwaukee, WI, a subsidiary of NM and limited purpose federal savings bank, and registered representatives of Northwestern Mutual Investment Services, LLC (securities), a subsidiary of NM, registered investment adviser, broker-dealer and member FINRA and SIPC. All NMWMC products and services are offered only by properly credentialed representatives who operate from agency offices of NMWMC.