7 Smart Tax Maneuvers in a (Still-) Lofty Market
Tips for tax-efficient rebalancing, conversions, and charitable giving.
While volatility has returned recently, there's no denying that stocks have performed well in 2018, far exceeding many observers' expectations.
It's hard to quibble with strong returns. But those gains--and the fact that they build on a long-running string of strong returns dating almost 10 years--have consequences.
One of them is imbalance: Many investors' portfolios are tilting more heavily toward stocks than they might have intended, which means they'll see more volatility in their portfolios when the going gets rocky, as it has recently.
And then there are taxes due on those gains. Indeed, a lofty market environment presents a lot of potential tax traps, as the appreciated winners in a portfolio that are most in need of trimming also carry the highest embedded gains.
As you assess your portfolio as 2018 winds down, here are some strategies to reduce your tax bill or at least ensure that you don't inadvertently pay more in taxes than you need to.
Don't Rule Out Tax-Loss Harvesting
Given the duration of the current equity-market rally, it's natural to discount the possibility of finding positions in your taxable portfolio that are trading at prices below what you paid for them. But don't rule it out. Individual equity investors are apt to find tax-loss harvesting especially fruitful: Of companies with market capitalizations of $10 billion or more, 377 have lost 10% or more of their value over the past 12 months, and 35 such companies (mainly foreign stocks) have dropped 10% on an annualized basis over the past five years. Even fund investors may be able to get in on the tax-loss-sale action, especially if they have recently purchased shares. Foreign-stock funds, in particular, have had a year to forget. Diversified emerging markets funds have dropped 9%, on average, over the past 12 months, and country- and region-specific funds (China, India, and Latin America) have logged double-digit losses.
Of course, the same positions that have dropped the most may be the ones that you'd like to retain exposure to, so it's important to pay attention to the wash-sale rule when tax-loss harvesting. If you'd like to retain exposure to an investment that you've just sold, you can't rebuy a "substantially identical" security within 30 days of selling without disqualifying the tax loss. Swapping an emerging markets ETF for a traditional index fund tracking the same benchmark won't fly, but selling an emerging-markets ETF and buying an actively managed emerging markets fund should be OK.
Consider Tax-Gain Harvesting If in the 0% Tax Bracket
While all but very unlucky investors will be able to identify many tax-loss sale candidates in their portfolios, investors who are in the 0% tax bracket for capital gains can ply an alternate strategy: tax-gain harvesting. In 2018, single filers with incomes of less than $38,600 and joint filers with incomes under $77,200 can sell securities they've owned for at least one year without triggering a tax bill. (Note that you need to factor your capital gain into your income to determine whether you fall under these thresholds.) The virtue of tax-gain harvesting is that you can wash appreciated positions out of your portfolio--and potentially improve its risk profile--without owing taxes. If you wanted to re-buy the same security immediately thereafter, that's permissible, too. Doing so will re-set your cost basis in the stock to today's higher levels, so if you're subject to capital gains tax in the future, the spread between your (more recent) purchase price and eventual sale price will be smaller. If the security declines in value after you've repurchased it, you may be able to take a tax loss. Tax-gain harvesting is a bit of a hassle but worth the effort.
Pick Your Spots for Rebalancing
If you've been hands-off with your portfolio, you have seen your equity holdings consume a larger and larger share of your balance. A portfolio that was 80% S&P 500/20% Bloomberg Barclays Aggregate Index would be over 90% equity today, while a 60% equity/40% blend 10 years ago would be more than 80% equity now. That shift isn't such a big deal for young accumulators, whose portfolios should be equity-heavy anyway. But it's more meaningful for people who are retired and expecting to draw upon their portfolios for living expenses. Not only will holding more stocks make their portfolios more volatile, but if any equity market shock materializes, they could be forced to draw upon depreciated equity assets for living expenses.
Selling equities pre-emptively through rebalancing reduces that risk. But any time you're thinking about selling appreciated winners, it's worth factoring in the tax consequences. For that reason, it’s best to concentrate your rebalancing activities in your tax-sheltered accounts, where you can without any tax consequences provided the money stays within the account. If rebalancing a taxable account feels urgent, consider directing new inflows to conservative holdings in the account to restore balance. Selling appreciated winners from a taxable account should be a last resort.
Be Strategic About RMDs
If you're over 70 1/2 and subject to required minimum distributions, you know that the die was cast on your RMD amount at the end of 2017; the amount that you need to take out of your IRA is calculated off of the prior year-end balance. Thus, you don't have the opportunity to reduce the RMDs you'll take this year. But you can still use RMDs as an opportunity to improve your portfolio. Even if you have multiple IRA accounts, you can be surgical about where you go for your withdrawals; the IRS only cares that you take the right amount for an RMD, not where you go for it. Right now, for example, many retirees are sitting on appreciated equity holdings; pruning the most highly appreciated positions for RMDs is a great way to restore balance to your portfolio and/or tee up cash for living expenses for next year. Retirees using the Bucket approach can use their RMD proceeds to refill Bucket 1. Doing so helps fulfill RMD obligations, and it also helps reduce equity-related volatility; having cash on hand to meet living expenses provides valuable peace of mind.
Tie in Charitable Giving
In a related vein, if you're charitably inclined and subject to RMDs you can take advantage of a qualified charitable distribution. With this maneuver, you steer up to $100,000 of your RMD directly to the charity(ies) of your choice. The beauty of the QCD is that the QCD amount isn't included in adjusted gross income. That can help keep you out of a higher tax bracket, qualify you for credits and deductions that you might not be eligible for with a higher adjusted gross income, and reduce the amount of your Social Security income that's taxable. The QCD is arguably even more beneficial under the new tax laws than it was in the past, as fewer households will be itemizing their deductions. That means that pulling out the RMD, depositing it into your account, and writing a check to charity won't give you the same tax benefit as the QCD, because you may not be itemizing your deductions.
You can't take advantage of the QCD if you're not yet subject to RMDs, but it's still possible to use charitable giving to reduce taxes and/or improve your portfolio. Even though you might not be able to itemize your deductions every year, including charitable contributions, you may be able to take advantage of a strategy financial planning guru Michael Kitces calls "charitable clumping"--bundling charitable contributions into one periodic mega-contribution.
Develop a Strategy for Mutual Fund Capital Gains Distributions
It's tough to predict how bad 2018 will be from the standpoint of mutual fund capital gains distributions. But the forces that have contributed to sizable mutual fund capital gain distributions in previous years--notably, strong market returns and investor redemptions from actively managed funds--are still very much in place. That means if you hold mutual funds, especially active ones, in your taxable account and are reinvesting your capital gains, you should formulate a strategy for dealing with these distributions. Of course, it's worth remembering that selling pre-emptively has the potential to trigger a different sort of tax bill: Even as you've dodged the distribution, you're still liable for taxes on any appreciation that has occurred in your shares over your holding period. On the other hand, if you own a fund that's been a "serial distributor" of capital gains, be aware that you've been receiving a step-up in your cost basis to account for the distribution that you received and reinvested but paid taxes on. In other words, thanks to that step-up, you've been prepaying your tax bill as you've been going along. Thus, the tax hit of conducting a tax-efficient portfolio makeover may be less than you'd expect.
Be Deliberate about IRA Conversions
A lofty market also calls for taking care if you're contemplating a conversion of traditional IRA assets to Roth. That's because the taxes due upon the conversion depend on your current balance, less any monies that you've already paid taxes on, such as nondeductible IRA contributions. With balances up, so will the conversion-related tax bills. That's why it's so valuable to take care--and get some tax advice--before proceeding with a conversion. Would-be converters should consider staggering their conversions over a period of years to avoid pushing themselves into a higher tax bracket with a single large conversion. Alternatively, they could take advantage of lower tax years--such as the period post-retirement but before required minimum distributions commence--to make conversions, as discussed here.