5 Ways to Shrink Your Tax Footprint
Consider careful asset location, selling losers (and winners), and using the specific-share identification method.
Investing Specialists
Note: This article is part of Morningstar's February 2014 Tax Relief Week special report.
As dedicated savers know, there are times when investing through a taxable account--rather than an IRA, 401(k), or 529 college-savings plan--is inevitable. Perhaps you have the high-class problem of having maxed out all of your available tax-sheltered vehicles: If you want to put additional money away, stashing it in a taxable brokerage account or mutual fund is your only option.
Alternatively, there may be times when you're saving for a goal that's close at hand. In that case, it doesn't make sense to lock up your money in a retirement account, where you'll usually pay taxes and a penalty to pull it out before retirement.
Saving in a taxable account can, at times, even be desirable. By holding assets with varying types of tax treatment--some tax-deferred (Traditional IRAs and 401(k)s), some Roth, and some taxable--you'll exert more control over your tax bill in retirement. Although you'll pay taxes on distributions from Traditional IRAs and 401(k)s in retirement, taxable-account distributions may be taxed at the lower capital gains rate, and Roth distributions will be tax-free.
Sure, holding some types of investments in a taxable account has the potential to lead to a big tax bill. For example, T. Rowe Price High-Yield (PRHYX) shareholders have surrendered nearly 3 percentage points of their returns to taxes during the past five- and 10-year periods. That's an outgrowth of the fact that high-income investors will be taxed on bond income at a rate of close to 40%.
But investing in a taxable account needn't jack up your tax bill. Just as you might aim to reduce your energy-usage footprint by taking public transport and turning down the thermostat, you can reduce the tax footprint of your taxable accounts by employing a few simple strategies.
Strategy 1: Watch What You Put Inside of Them
One of the keys to making sure your taxable accounts aren't generating excessive income and capital gains, on which you'll owe taxes even though you haven't sold a share, is to be careful about what types of assets you hold inside them. Reserve high-turnover equity funds and high-income bond funds for IRAs and 401(k)s, where they can generate income and capital gains distributions all year long and you won't pay a dime in taxes. (You'll just owe taxes when you sell.)
For the long-term component of your taxable accounts, focus on index-equity funds and individual stocks. The former tend to generate few taxable capital gains distributions. Meanwhile, individual stocks enable you--rather than a fund manager--to decide when to realize a capital gain. Tax-managed funds can also be worthwhile in categories that aren't necessarily tax-efficient, such as in the small-cap sector, where managers sometimes have to sell their winners to stay within their prospectus' market-cap parameters.
For the shorter-term portion of your portfolio, consider holding municipal-bond funds, the income from which is typically free of federal, and in some cases state, taxes. Munis have gotten beaten up during the past year as worries over municipal finances and investor selling have roiled the market, making their yields pretty attractive relative to taxable-bond yields; those yields look even more attractive once you factor in the tax benefits.
Strategy 2: Limit Your Own Trading
Giving due attention to asset location will help limit unwanted taxable distributions. But you have to do your part on an ongoing basis, too. That means that once you have your taxable portfolio plan up and running, plan to trade infrequently, if at all. The goal is to avoid realizing unnecessary capital gains, especially short-term ones, which are taxed as ordinary income. It helps if your holdings are well-diversified, low-maintenance core holdings like index funds and U.S. blue-chip stocks; that way you're not likely to be confronted with star manager drama, questions about a company's financial health, or performance that is dramatically worse than the broad market's.
Strategy 3: Sell Your Losers
Even as you want to exercise patience with the holdings in your taxable portfolio, it's still a good strategy to periodically scout around for positions that have dropped in value. You can use those losses to offset capital gains elsewhere in your portfolio or, if your losses exceed your capital gains, to offset ordinary income. You can even rebuy the same security, provided you wait more than 30 days after the sale, and still take the tax loss. After a five-year runup in the equity market, losing stock positions are few and far between in many portfolios right now, but tax-loss selling can provide a rare silver lining in lousy markets.
Strategy 4: Step Right Up, at No Charge
In a related vein, investors who are in the 15% tax bracket and below should consider selling their winners right now. That's because they currently pay no tax on long-term capital gains. If these investors' securities have appreciated beyond their purchase prices and they've held them longer than a year, they can sell their winning holdings and rebuy them straightaway. In the process, they'll have reset their cost basis in their holdings to the new, higher levels. Thus, if they eventually do enter a higher capital gains tax bracket, they'll be paying tax on the difference between the higher purchase price and the sale price.
Strategy 5: Be Specific About Cost Basis
Another way to limit your tax footprint is to use the specific-share identification method for reporting your cost basis on your investments. At the most basic level, cost basis is simply the amount you've paid for an asset. The difference between your cost basis and the price at which you sell that asset is used to determine the amount of capital gains tax you owe on the transaction.
Investors can use various methods for determining their cost basis, and they must specify with their providers which method they'd like to employ. (Fund companies and brokerage firms are now legally required to track their clients' cost basis and report this information to the Internal Revenue Service.) The most flexible method--and the one that gives investors the most latitude to keep their tax bills down--is what's called the specific-share identification method. The basic idea is that you can pick and choose which block of shares you'd like to sell. For example, say you've purchased a stock at several intervals across a number of years. If a batch of newly purchased shares drops sharply in price, you can tell your brokerage firm to sell that group, thereby taking a tax loss, while leaving your other, highly appreciated shares intact. This article provides more detail on the various cost-basis methods.
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