Give your taxable account a lift by replacing tax-loss-sale holdings with better investments or by finding more tax-efficient alternatives, says Morningstar's Christine Benz.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It might be hard for investors to see the upside in the negative equity performative we've had so far this year. But Morningstar's director of personal finance, Christine Benz, thinks there are some good strategies that investors can use to improve their taxable portfolios in a time like this.
Christine, thanks for joining me.
Christine Benz: Jeremy, great to be here.
Glaser: Before we look at the strategies, let's just talk a little bit about why you might want a taxable portfolio, particularly for retirement. Why should you look at this versus just saving exclusively in IRAs or 401(k)s?
Benz: Certainly, with IRAs and 401(k)s, you will be eligible for that tax-break rate at the outset of your contribution. That's certainly the case if you are making any 401(k) contribution, and it may be the case if you are eligible for tax-deductible IRA contributions. So, you do get that immediate gratification with those types of accounts.
There are a few key reasons to consider saving in a taxable account as well. The first is liquidity. You may be multitasking in that account, so you can pull the money out of a taxable account without having to explain to anyone about what you're doing or without having to meet any requirements whatsoever. So, that's a big advantage. Another advantage is that there are only so many tax-sheltered receptacles to go around. There are contribution limits that apply to all of these tax-sheltered account types, and some heavy savers may want to put even more away. So, taxable accounts are the natural receptacle for those assets.
The last reason really comes in during retirement. You think about Roth IRA assets or Roth 401(k) assets as being the most advantageous to bring into retirement because you're able to take qualified withdrawals tax-free. They are in the most beneficial category. Traditional tax-deferred vehicles--like traditional 401(k)s or traditional IRAs--are kind of ugly when it comes to pulling money out during retirement because all of that money will be taxed at your ordinary income tax rate.
I would say that taxable accounts fall somewhere in between. So, yes, if you are earning ordinary income in a taxable account, that's going to be subject your ordinary income tax rate; but if you have stocks in your account and you're holding them for the long term, you'll be eligible for the long-term capital gains rate, which is currently quite low. In fact, it's zero percent for investors in the lowest tax brackets. So, I would say that, in retirement, you'll be glad that you have brought some taxable assets along.
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Glaser: Let's look at some of those strategies to improve that account, particularly given the down market we've seen. The first one that comes to mind is tax-loss selling. Why would that be a good thing to a look at now?
Benz: Certainly, it's a good thing because you can use those tax losses if you have securities where your purchase price is above their current price; you can take the loss, sell the securities, and use that loss to offset capital gains for 2016, if you have them. Or if your losses exceed your capital gains, you can use them to offset up to $3,000 in ordinary income taxes. So, the tax losses can be very advantageous for investors who do have securities that are depressed.
Glaser: If you do a tax-loss sale, you might be losing exposure to an area that's beaten down and might have better prospects in the future. If you want to keep exposure there, what's a good way to maybe increase the quality without getting into a wash-sale-rule situation?
Benz: It's really important to keep the wash-sale rules in mind when you are engaging in tax-loss selling and you're thinking you want to supplant something that you've sold with something else that occupies a similar space. You do need to be careful if you're making that replacement within 30 days of having made the sale that the security you are buying in place of what you've sold isn't considered substantially identical.
Two great examples of securities that would be substantially identical are Berkshire Hathaway Class A (BRK.A) and Berkshire Hathaway Class B (BRK.B) or supplanting an S&P 500 index fund with an S&P 500 index ETF. Those would be swaps that would trigger the wash-sale rule.
On the other hand, you do have quite a bit of leeway to make other changes to maintain economic exposure to a given part of the market while not rebuying substantially identical securities. Here's a good example: Maybe you have some sort of individual energy stock, and you want to make sure that you stay exposed to that very beaten-down area; you might supplant it with, say, a broad or semibroad energy-specific exchange-traded fund. That would be allowable, and that would allow you to maintain exposure to that area.
The idea of upgrading--which you mentioned, Jeremy--I think is a really important one. Not only are you able to take the loss and improve your tax position, but you may in fact improve your portfolio's forward-looking prospects as well. A great example is, if you're an individual-equityholder and you've got a security that's a 2-star stock currently with no moat, you could look around, do some screens, and replace it with a company that our analysts really like within that same sector that has a lower price/fair value ratio and has a wide moat. So, you do have some leeway, certainly, to improve your tax position and improve the quality of your holdings on a forward-looking basis.
Glaser: Your second strategy is that even if you don't have any tax-loss harvesting to do, it's still a good time to think about a tax-efficient makeover. What do you mean by that?
Benz: Well, I mean that investors may have securities in their taxable portfolio--even if they aren't good tax-loss-sale candidates--that may be tax-inefficient. Maybe they've been tax-inefficient in the past, and they figure to be pretty tax-inefficient going forward. So, it's a reasonable time now that things are down a little bit to think about making some changes there. The tax hit that you will incur to make those changes will be less than would have been the case, say, a year ago.
A great example is that a lot of investors are going along with actively managed mutual funds in their taxable accounts, and what they've found--what I've found in having actively managed funds in my taxable account--is that they've been pretty tax-inefficient over time. You've got these funds making big capital gains distributions, in part, because some funds have had redemptions, so the managers have had to sell stuff to pay off departing shareholders. That means that shareholders who stick around get stuck with big capital gains tax bills.
So, if you are looking to address that issue--to make your portfolio more tax-efficient on a forward-looking basis--you could think about taking a look at your cost basis in those funds; if things are a bit beaten down, you may be able to sell those securities and start at least transitioning your portfolio to more tax-friendly holdings. So, here, I'm thinking of broad-market equity index funds, exchange-traded funds, or perhaps tax-managed funds. Those would be all categories that we would consider to be more tax friendly on a forward-looking basis.
So, do that analysis and check your cost basis. Even though things are quite beaten down here in 2016, stocks have had a good run; so it may still trigger some tax costs to make these changes. So, definitely check your cost basis. Fund companies and brokerage firms do a pretty good job of helping investors analyze their tax position in their holdings. So, do that work before you initiate any of these changes.
Glaser: Christine, thanks for sharing these strategies today.
Benz: Thank you, Jeremy.
Glaser. For Morningstar, I'm Jeremy Glaser. Thanks for watching.
