Opinion: How to help mitigate tax consequences

Solid investment returns are important to financial success. However, it’s not just what an investor earns that matters.  

It’s also about the after-tax returns—what the investor gets to keep. There are many strategies to help investors mitigate taxes during the investment process.

Asset location
For investors with a combination of taxable, tax-deferred and/or tax-free accounts being managed for the same purpose, opportunity exists to select which assets are purchased in the various account types. Buying the least tax-efficient assets in tax-deferred accounts and the most tax-efficient assets in taxable accounts can help improve after-tax returns. So, what does that look like?

Within the current tax code, long-term realized capital gains are normally taxed at a lower rate than short-term realized capital gains and taxable interest. With price appreciation typically being the primary component of stock returns, and given advantageous long-term capital gains rates, maintaining more stock exposure in a taxable account can improve tax efficiency.

Conversely, alternative investments commonly distribute short-term capital gains, and taxable bond investments generate taxable interest, which could make both good candidates for tax-deferred accounts. In tax-free or Roth-type accounts, investing in assets with the highest expected long-term returns often makes sense, since this growth isn’t expected to be subject to future taxation.

Security selection
Using index funds and tax-exempt bonds for investment portfolios also can improve after-tax results. Index funds replicate a particular index without subjective decision making by the manager. Because of this passive approach, index funds tend to have fewer purchases and sales, since the constituents of any given index are fairly constant over time. Fewer trades typically mean lower capital gains distributions compared with actively managed funds, leading to greater deferral of taxes.

Tax-exempt municipal bonds usually generate federal and sometimes state tax-exempt income. Typically, tax-exempt bonds offer lower interest rates when compared with taxable bonds of similar quality and maturity. However, after-tax returns often are still higher for taxpayers in the top tax brackets.  

Tax-loss harvesting
Periods of market volatility can afford investors the opportunity to harvest losses from positions trading below their cost. When harvesting losses, the proceeds from selling the security are reinvested in a replacement position with equal or superior investment characteristics, or the proceeds are held in cash to be reinvested into the same security after 30 days pass. The realized losses then may be used to offset gains realized in the same year or carried forward to offset future-year gains.

Cost-basis accounting method
Most custodians and brokerage firms offer several methods of applying cost basis to securities sales. Unless you or your investment adviser have consciously made an accounting method selection for your portfolio, the first-in, first-out method will often be applied as the default.  

The FIFO accounting method applies the cost basis of the oldest lots of a security to a sale. This means the tax lots of the first security acquired will be sold first. Commonly, the oldest tax lots are the lots with the most embedded gain, making the FIFO method less than ideal from a tax management standpoint. Other cost-basis accounting methods are available that may be more effective in mitigating capital gain taxes.  Check with your custodian or investment adviser to see which of the available options might be best for you.

Partnering with a tax adviser
You or your investment adviser may uncover additional ways to manage assets more tax efficiently, relative to your situation, by consulting with your tax adviser. Some strategies you could discuss with your tax adviser include the use of appreciated securities for charitable gifting, calculated individual retirement account conversions, establishing a donor-advised fund and directly paying IRA management fees.

An active effort to manage the tax implications of your investments can increase after-tax returns and improve the odds of achieving financial success.

Stephanie Hurt is a senior managing adviser for BKD Wealth Advisors LLC. She can be reached at shurt@bkd.com.

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