5 Tax Pitfalls to Avoid in a Lofty Market
What helps improve your portfolio can also increase the taxes you owe.
I’ve said it before: When it comes to portfolio management, a policy of benign neglect invariably beats a too-active one.
Yet even hands-off investors should consider changes once in a while. Portfolio contents shift around--sometimes substantially. Account types that made sense for you at one life stage may no longer fit. And so on. To set your portfolio up for good results in the future, sometimes you have to take action.
Yet even as you might have a growing to-do list of to-dos related to your portfolio, there’s a countervailing force to reckon with: taxes. Actions that make all the sense in the world, whether rebalancing or converting traditional IRA assets to Roth, can entail tax costs, and those costs can be exacerbated in bull markets like the one we’ve experienced for the past decade-plus.
If you’re surveying your portfolio and scoping out potential changes or other actions you’d like to take at this late date in the current bull market, here are some key tax-related pitfalls to avoid.
Rebalancing From Taxable Accounts
Ten-plus years into a bull market--and especially after the past stellar six months--it isn't hard to make the case that many investors need to rebalance. While bonds have performed pretty well, too, a portfolio that was 80% S&P 500/20% Bloomberg Barclays U.S. Aggregate Bond Index would be more than 90% equity today. Meanwhile, a 60% equity/40% bond blend 10 years ago would be more than 80% equity now.
Younger investors--really anyone under 50, in my opinion--might reasonably sit tight with an equity-heavy mix, assuming they feel somewhat confident they won’t panic when stocks inevitably fall. But people who are retired or getting ready to retire should consider trimming their appreciated equity holdings in favor of the safe stuff, cash and bonds. If they don’t and the market tumbles, they could be forced to draw upon depreciated equity assets for living expenses.
Yet here’s a classic case where doing what’s right for your portfolio can be all wrong for your tax bill. If you lighten up on appreciated holdings in your taxable accounts, you’ll owe capital gains taxes on the appreciation. Meanwhile, rebalancing your tax-sheltered accounts, where you may well hold the bulk of your money anyway, won’t entail tax consequences as long as the money stays inside the account. If you must rebalance your taxable account and are still in accumulation mode, you may be able to address the imbalance without affecting your taxes by directing new contributions to the underweight positions in the account, not selling.
Not Taking Advantage of 0% Rate for Capital Gains
A hands-off approach to taxable holdings isn't always warranted, though, because not every investor pays capital gains tax. In 2019, single filers with incomes of less than $39,375 and joint filers with incomes under $78,750 can sell securities they've owned for at least one year without triggering a tax bill. (Bear in mind that those capital gains factor into income.) That gives people in that situation some leeway to address problem spots in their taxable portfolios, such as uncomfortably high equity weightings, without triggering a tax bill.
Another great aspect of so-called “tax-gain harvesting” is that there’s no rule against re-buying the same security, even right away, if you wish to maintain exposure to it. Why would you do that? To re-set your cost basis in the stock to today's higher levels. Thus, if you're subject to capital gains tax in the future, the taxes you owe on the difference 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.
Not Exercising Caution on Conversions
Tax issues related to a bull market aren’t the exclusive domain of taxable investors. Investors who would like to convert Traditional IRA balances to Roth may find that a lofty market is a less opportune time to do so than a weak one. That's because the taxes due upon the conversion depend on the current balance, less any monies that you've already paid taxes on, such as nondeductible IRA contributions. With balances up, the conversion-related tax bills will be, too.
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 postretirement but before required minimum distributions commence--to make conversions.
Not Tying in Portfolio Maintenance With Charitable Giving
Not marrying portfolio changes with charitable giving may not be an outright mistake, but it is a missed opportunity for people who are charitably inclined. There are a couple of ways that you can improve your portfolio’s positioning and make a charitable gift at the same time.
One tried and true option, available to investors at all life stages, is giving appreciated securities from your taxable account to charity, either directly or via a donor-advised fund. If you’ve lightened up on a security to reduce your portfolio’s risk level or otherwise improve it, giving it to charity amounts to a three-fer: You’ve made a charitable gift, you’ve improved your portfolio, and you may be able to take a tax deduction on the contribution, provided you’re itemizing your deductions. That said, the new, higher standard deduction amounts mean many fewer taxpayers will be itemizing. That burnishes the value of "bunching" deductible items like charitable contributions into a single year to clear the standard deduction hurdle.
Charitably inclined retirees who are subject to required minimum distributions also miss an opportunity if they don’t make their charitable contributions via qualified charitable distributions. 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.
Resigning Yourself to Big Tax Bills Related to Your Mutual Funds
Last but not least, you might assume that big capital gains distributions are just the cost of making money: While selling before a distribution may help you dodge that particular capital gain, the sale of your own shares could trigger an even larger one. That risk might seem particularly pronounced this late in the market’s current bull run.
If you own a fund that's been a "serial distributor" of capital gains--and funds have made some doozies in recent years--and you reinvested the distributions and paid taxes on them, you’ve essentially already prepaid some of the taxes that you’ll owe when you sell your shares. Thus, it’s a mistake to assume that you’re captive in the tax-inefficient fund; you may be able to switch into an exchange-traded fund or index fund and owe less on the transaction than you expected.
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