Conduct a Tax Audit of Your Portfolio

Note: This article is part of Morningstar's 2018 Portfolio Tuneup week. A version of this article appeared on July 9, 2017.

When the market has been as good as it has been lately, it might be tempting to crack open your investment statement or online portfolio tool, smile at your enlarged balance, and call it a day.

But the fact that market returns have been so strong over the past nine years makes it more important, not less, to dig into the details. After all, strong past returns typically portend lower returns; several market experts have suggested that U.S. equity returns over the next decade could be in the low single digits. And when you're starting with a low raw return, trimming investment and tax costs can make a big difference in how much of those gains you can actually pocket.

For that reason, I'd suggest that you incorporate a periodic tax audit into your portfolio review process. Don't worry: You don't need to be a CPA to review your portfolio's tax efficiency; unlike actual auditors, you won't have to hole up in a cubicle and order in lunch. Rather, answering the following questions can help you review the tax efficiency of your portfolio and potentially identify areas for improvement. Question 1: Are you taking full advantage of tax-sheltered accounts? If you're still contributing to your investments, it's wise to prioritize contributions to the accounts that give you a tax break for doing so. Of course, it's Investing 101 to stash any retirement savings in a employer-sponsored retirement plan like a 401(k), 403(b), or 457 plan; such plans offer automated contributions and your employer may match you on the money you put in. In 2018, the annual limit for contributions to such plans is $18,500 for the under-50 set and $24,500 for workers older than 50. Self-employed investors use a different suite of retirement-savings vehicles; my favorite is the Solo 401(k), which largely mirrors an employer-provided 401(k). If you don't have an employer-provided plan, your plan isn't that good, or--best-case scenario--you're already making a full contribution to a company retirement plan and have still more money to invest for retirement, prioritize a contribution to an IRA. For 2018, the IRA contribution limits are $5,500 for those younger than 50 and $6,500 for investors 50 and older. In contrast with company-provided plans, where income limits don't affect eligibility, IRA contributions are governed by income limits, outlined here.

Finally, super-savers who are maxing out both company retirement plan and IRA contributions and still have more to invest should take a look at an aftertax 401(k) as a possible option for additional retirement savings. Assets in such accounts can be rolled over to a Roth IRA upon retirement or your departure from your employer, providing additional tax-sheltered retirement savings. Question 2: Are you making smart choices about traditional versus Roth accounts? Whether you're contributing to an employer-provided plan, a Solo 401(k), or an IRA, you've no doubt hit a fork in the road: traditional or Roth? If you contribute to a traditional account, you may be able to receive a tax break on the contribution but you'll pay taxes on your money when you pull it out in retirement, and you'll also be subject to mandatory distributions once you pass age 70 1/2. Roth accounts offer the opposite tax treatment: no tax breaks on contributions, but qualified withdrawals are tax-free and required minimum distributions don't apply to Roth IRA accounts.

To help guide your decision-making about whether to go Roth or traditional, ask yourself whether your tax rate is apt to be higher at the time of the contribution or when you pull the money out in retirement? If you're just starting out, earning a meager salary, and paying tax at a fairly low rate relative to what's likely to be the case in the future, Roth contributions are the way to go. On the other hand, if you think your tax rate today is fairly high relative to where it will go in the future--for example, you're still working but you expect that Social Security will provide most of your retirement income--prioritize traditional contributions. If you have no idea about your tax rate now versus later on, splitting your contributions across both account types is sensible. Bear in mind, too, that income limits on IRAs may force your hand regarding traditional versus Roth, though investors of all income limits can get into a Roth IRA via the "backdoor" maneuver. Question 3: Are you taking advantage of tax breaks for nonretirement savings? The government provides tax breaks to incentivize desirable savings behaviors. Amassing assets for retirement tops the list, but investors also get tax breaks for stashing money away for education and out-of-pocket healthcare expenses.

That means that investors saving for education should run their contributions through a 529 college savings plan or Coverdell Education Savings Account; Morningstar's 529 Center helps investors sift through the best and worst plans by state.

Meanwhile, health savings accounts are valuable tools for people covered by high-deductible healthcare plans, offering pretax contributions, tax-free compounding, and tax-free withdrawals for qualified healthcare expenses. (Because of those unmatched tax benefits, affluent investors may be better off paying health expenses out of pocket and leaving their HSA assets undisturbed.) One knock against HSAs is that many are hobbled by high costs and/or weak investment options; Morningstar has begun to shine a light on this universe via its recently released health savings account report, discussed here. Question 4: Are your taxable accounts as tax-efficient as they can be? If you've ventured beyond tax-advantaged accounts for your investments and are investing inside a plain-vanilla brokerage account, remember that you'll be on the hook for any income or capital gains payouts that your investments kick off, and that's true even if you reinvest those distributions. The good news is that if you follow a few simple principles, you can bring the ongoing tax drag way down.

Start by keeping investments that kick off (relatively) high income in your tax-advantaged accounts; topping the list of taxable-account "don'ts" are high-yield bonds and bond funds, real estate investment trusts, and commodities investments. If you must hold bond and bond funds in your taxable account, use the tax-equivalent yield function of Morningstar's Bond Calculator to gauge whether municipal bonds might not be the better bet; their income is typically free of federal taxes and in some cases state and local levies, too. For diversification and to limit bond-trading costs, I favor a muni-bond mutual fund rather than individual municipal bonds.

If you hold stocks in your taxable account, broad-market equity index funds and exchange-traded funds tend to make few capital gains and therefore are ideal taxable-account holdings. Individual stocks and tax-managed funds are also good bets. On the flip side, avoid mutual funds that have a history of making big capital-gains distributions; scan your latest tax returns to see whether you're holding any serial distributors in your taxable account. Because you've already paid taxes on those distributions, which effectively increases your cost basis, giving your portfolio a tax-efficient makeover may cost less than you think. (Ask your accountant for guidance.)

Question 5: Can you spot any opportunities for tax-loss (or tax-gain) harvesting in your taxable accounts? One nice thing about withdrawals from taxable accounts is that when you pull your money out, you'll only owe taxes on the appreciation. (After all, you put aftertax dollars into the account, so the amount you put in, sometimes called your cost basis, won't be taxed again.) Moreover, your taxable withdrawals will be taxed at your capital gains rate, provided you've been investing in that stock or fund for at least a year; today, such rates are quite low relative to where they've been historically.

Additionally, when investors in taxable accounts sell securities for less than they paid for them, they're able to take a loss on the sale. These losses can be applied to future gains; harvesting them can be a way to find a silver lining in down markets. Nearly nine years into a bull market, it's a rare mutual fund that's in negative territory, though long-suffering investors in precious metals funds may be the exception. But investors in individual equities may be able to find some losers.

If your income qualifies you for the 0% tax rate on long-term capital gains (for 2018, it applies for single taxpayers with incomes between $0 and $38,600 and married couples filing jointly with incomes between $0 and $77,200), tax-gain harvesting is a strategy worth considering, particularly given the length and breadth of the rally in stocks. That's because you can sell appreciated securities with no tax costs. You can then sell and "upgrade" into something better, or even re-buy the same security. Re-buying the same stock or fund resets the cost basis to today's higher level, thereby setting up the opportunity for tax-loss harvesting down the line, or at least reducing any capital gains taxes that might eventually be due.

Question 6: Do you have a plan for in-retirement withdrawals? Once you're retired and drawing from your portfolio for living expenses, it's inevitable that you'll owe some taxes on at least some of the money that you take out. Tax-efficient withdrawal sequencing--taking a holistic view of your other income and deductions to help determine which investment accounts to pull from in any given year--can go a long way toward reducing your tax burden over your retirement time horizon. As a general rule of thumb, retirement planners suggest that taxable assets should go first in the withdrawal queue, because their tax benefits aren't all that great, followed by tax-deferred and Roth assets. But there may be years in which you'd flout those rules, pulling from tax-deferred or Roth accounts instead of taxable.

Although you can't dodge required minimum distributions once they commence, I love the idea of being artful about sourcing them. Rather than pulling your distribution from your cash account or taking a piece of each of your holdings, use RMDs to improve your portfolio's risk/reward profile. If you're too stock-heavy, for example, trim your most highly appreciated equity holdings, thereby reducing your portfolio's risk level.

Question 7: Is your portfolio connected with your charitable-giving strategy? Most people know that donations to qualified charities are tax-deductible. But you can get even more oomph from your charitable contributions if you involve your investment portfolio. By donating appreciated securities from your taxable account, you can both avoid the capital gains that would otherwise be due while also obtaining a tax deduction for the fair market value of the securities--a two-fer. Nor will the charity owe tax on the appreciated securities it receives from you. Charitably inclined investors should also investigate a donor-advised fund. By steering appreciated securities into such a fund, investors can avoid capital gains tax on the appreciation and obtain a tax deduction, then move deliberately to invest the money and donate it to the charities of their choice. Finally, retirees who are subject to required minimum distributions can take advantage of qualified charitable distributions, steering up to $100,000 of their required minimum distributions to the charity or charities of their choice.