The rest of 2012 presents a new incentive to make sure your investment accounts are cleaned up and your portfolio is well-organized. Given tax changes that are coming next year, there are three critical areas of portfolio management that can collectively save money on taxes and potentially improve investment performance.
People who want their money to work hard for them should consider:
• Can you take advantage of the last few months of lower tax rates to revise your holdings at lower costs?
• Is the account type that different investments are held in the most optimal for generating after-tax returns?
• Is your overall mix of assets well aligned with your goals and comfort for dealing with market risk?
COMING CHANGES
When the calendar turns to 2013, tax rates on capital gains and dividends are scheduled to increase, dramatically in some cases. This will make the location of various types of investments more important than it has been for the past several years.
The long-term capital gains tax – on assets sold after being held more than one year – is applied against gains on investments that were not held in tax-deferred retirement accounts. This tax rate is currently zero for people in the bottom two tax brackets. That’s up to $35,350 of adjusted gross income for an individual taxpayer or $70,700 if you’re married filing jointly. If this is your situation, you can sell winners this year and pay no capital gains tax. If you sell and realize gains after January 1, the tax will be 10 percent of the gain.
The capital gains tax is 15 percent for all higher tax brackets. Next year, the capital gains tax in higher income brackets is scheduled to rise from 15 percent to 20 percent – a 33 percent increase.
If you intend to sell an investment with a capital gain in the next few years, you could significantly reduce the tax bill by going ahead and selling it this year. You can either use the proceeds to fund immediate spending needs or simply reinvest it, having taken the gain out of the equation at a lower tax consequence.
The same tax-bracket parameters currently apply to income from qualified stock dividends.
However, in 2013, dividend income is scheduled to be treated like ordinary income. For high income people, tax on dividends could nearly triple.
LOCATE ASSETS FOR TAX EFFICIENCY
The more long-lasting effect of your year-end portfolio cleanup may be gained from a review of the location of your investments. A lot of attention is given to asset allocation – your mix of stocks, bonds, alternative investments and cash – but the changing tax rates raise the need to be mindful of asset location. Certain types of investments may be better off in specific types of accounts.
While the asset allocation decision is still paramount in crafting your overall investment strategy, asset location can help you keep more of your returns in the after-tax world – the only place where you can spend your money. Over time, increasing your after-tax return, even by just a fraction of a percentage point each year, will make a big difference.
ASSET LOCATION PREFERENCES
Assets that pay regular income should be kept in tax-deferred accounts such as Traditional IRAs or the assortment of employer retirement plans. Most types of bonds and Real Estate Investment Trusts are clear examples. Next year, stocks that pay large dividends may be better held in tax-deferred accounts as well. There is no tax due from year to year in IRAs, 401(k)s and other pre-tax retirement savings vehicles. Taxation is deferred until assets are removed from the account, possibly years from now in retirement when your tax bracket may be lower.
If you have a Roth IRA or Roth 401(k) option, the best investment for it is the one with the highest growth potential. Investment gains and dividends in Roth accounts are tax free. This is where you would ultimately like to hold your Apple stock of the past several years or your emerging markets funds, whatever you expect to have the highest return over time. If you keep more stable, low-growth holdings in the Roth, it would dilute the account’s greatest benefit. In taxable accounts, it’s generally best to hold investments that do not pay regular income. Certainly non-dividend paying stocks or stock index funds can go here first.
Not everyone’s preferred mix of investments accommodates the most tax-efficient location. Conservative investors may want more bonds in their portfolio than their tax-deferred accounts can hold. More aggressive investors will need to hold some capital-gain oriented investments in an IRA or 401(k) that will be taxed at less advantageous ordinary income rates.
This is not a problem if it is what it takes to get to the right asset allocation for your personal comfort, benefitting from tax efficiency as much as you can.
Gary Brooks is a certified financial planner at Brooks, Hughes & Jones a registered investment adviser in Old Town Tacoma. Reach him at gary@bhjadvisors.com.
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