By Sheryl Rowling
SAN DIEGO — Question: My portfolio is managed by an investment manager. How can I tell if my manager is focusing on tax efficiency?
Answer: This is a great question and reflects the dilemma investors face. Returns are not spectacular these days, yet taxes never seem to decline. Combined Federal and state tax rates can reach close to 50 percent. Thus, managing investments for tax efficiency can make a huge difference in how much money you actually have available long term.
Want to judge your manager? Take a look for these clues:
- Does your taxable account produce large short-term gains? Selling an appreciated investment before you’ve held it for at least a year results in ordinary tax (with Federal rates up to 39.6 percent) rather than capital gain tax if held for a year or more (with Federal rates from zero to 20 percent). Your advisor should minimize short-term gains. Otherwise, you are likely paying twice as much tax than you should be.
- Does your taxable account show loss sales when the market takes a dip? The right answer is “yes.” When the market falls, it’s time to make lemonade out of the lemons with tax loss harvesting (TLH). TLH means that you sell shares solely to recognize a tax loss. It might seem easy to sell at a loss then immediately buy back what you sold. That way, you get a deductible loss while staying invested, right? Unfortunately, the IRS blocks this strategy by not allowing the loss if you buy back the same (or substantially similar) security within 30 days. So, a tax-smart manager will sell the loss position and immediately buy something similar that is not substantially similar. For example, you could sell shares of an S&P index fund and replace them with shares of an actively managed large cap fund.
- Does your taxable account hold municipal bonds? If you are in a low tax bracket, you should own taxable bonds, not muni bonds. If you are in a high tax bracket, it is appropriate to hold muni bonds.
- Does your retirement account hold stocks while your taxable account holds bonds? If so, your manager is not managing tax efficiently. When you hold stock (an appreciating investment) in your taxable account, you don’t pay tax on the growth until you sell the investment. As long as you’ve held it at least a year before selling, you will pay capital gain tax. If held at death, the investment steps up to fair market value – meaning your heirs will not pay tax on the appreciation. If you hold stock in your retirement account (or IRA), there is no tax while it is growing (just like in the taxable account). When you take money out of your retirement account (“sell”), the growth is taxed at ordinary rates. So, if you hold stock in your retirement account, it’s like telling Uncle Sam you’re okay with paying twice as much tax!
- Are sales in your taxable account tracked using “average cost” or “FIFO” (first in, first out)? If so, your manager is using a default “cost basis” rule – meaning that he or she is not choosing high cost lots to minimize taxable gains. Find out the cost basis rule your manager is using. “High cost”, “best tax” or “specific identification” is good. Average cost or FIFO is not.
There are other ways a good manager can cut your tax bill. If your manager doesn’t make the cut, you should find yourself a new advisor. Look for CPA financial advisors (like CPA/PFS), fee-only advisors (National Association of Personal Financial Advisors) and/or Registered Investment Advisors. Check out www.aicpa.org or www.napfa.org.
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Rowling is a certified public accountant, personal finance specialist, and principal of Rowling & Associates. She may be contacted via sheryl.rowling@sdjewishworld.com. Comments intended for publication in the space below must be accompanied by the letter writer’s first and last name and by his/ her city and state of residence (city and country for those outside the U.S.)