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Investing Specialists

4 Strategies for Improving Your Portfolio Without Triggering Extra Taxes

Addressing portfolio problem spots often involves a tax bill; here's how to avoid paying extra and possibly even save.

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The current rally in the equity market passed the 10-year mark in March. That’s wonderful news for portfolios: Average 401(k) and IRA balances at Fidelity Investments, for example, exceeded $100,000 as of the second quarter of 2019, and the number of “401(k) millionaires” also increased. 

But enlarged balances also owe a great deal to the stock market’s extended tear, meaning that some investors’ portfolios may be courting more risk than would be ideal.

After all, a portfolio that was 60% equity/40% bond 10 years ago would about 80% equity today. In addition to enlarged equity weightings, investors’ intra-asset-class exposures may have also shifted around. Growth stocks have trumped value, leaving many investor overexposed to the right side of the Morningstar Style Box relative to a “neutral” baseline like a total stock market index. And while international equities have performed admirably recently, they’ve lagged U.S. names dramatically over the past decade and are therefore underrepresented in many investors’ portfolios.

The problem is that stripping back on the appreciated portions of your portfolio, whether to reduce risk, set it up for better returns going forward, or both, can trigger tax costs by unleashing taxable capital gains. That’s why the first line of defense when adjusting your portfolio should be to concentrate any portfolio adjustments in your tax-sheltered accounts. If you’re like most investors, most of your money is concentrated in your IRAs and 401(k)s anyway, and you won’t owe any taxes on those adjustments, provided your assets stay within the confines of the account.

Yet there are additional techniques that you can use to adjust your portfolio without triggering tax costs, even some that extend to your taxable holdings. If you tie in charitable giving, you may even be able to reduce your tax bill relative to what it would have been had you done nothing. These strategies are particularly worth considering as 2019 winds down and investors often turn their attention to adjusting their portfolios and making decisions to reduce their tax bills.

Strategy 1: Qualified Charitable Distribution
As noted above, concentrating any portfolio changes in your tax-sheltered accounts is a key way to make sure you won’t owe taxes, even if you scale back appreciated winners. But if you’re older than age 70 1/2 and own accounts that are subject to required minimum distributions, you have yet another tool in your tool kit: the qualified charitable distribution. Using this strategy, you can steer your RMD from your IRA, up to $100,000, into the charity or charities of your choice. (RMDs from company retirement plans aren’t eligible for the QCD.) The QCD amounts don’t affect your taxable income as would an RMD that you took and spent or reinvested; from a tax standpoint, it’s as though you didn’t take your RMD at all, even though you've fulfilled your obligation to the IRS. The QCD is particularly compelling under the new, higher standard deductions, which means that many fewer taxpayers will benefit from itemized deductions, including charitable contributions, than in the past.

How can you use QCDs to improve your portfolio? As with any RMD, you can be deliberate about which securities you prune to raise the funds for RMDs; there’s nothing saying that you need to give all of your holdings a haircut, as long as you take the right RMD amount from your IRAs overall. For example, a retiree whose overall equity exposure is higher than he would like can raise the funds for the RMD by paring back the most highly appreciated holdings that likely need a trim due to valuation considerations. The proceeds, in turn, can be steered into a QCD.

Strategy 2: Donating Appreciated Securities From Your Taxable Account to Charity
If you aren’t yet subject to RMDs, you have fewer opportunities to benefit, taxwise, from charitable contributions. That’s because the tax laws that went into effect for the 2018 tax year generally make itemizing deductions less advantageous; the standard deduction will be higher for most households than their itemized amounts. (Charitable contributions are a type of itemized deduction.) That said, if you’re charitably inclined you may benefit from bunching your charitable contributions together into a single year rather than making smaller charitable contributions over several years.

By tying in your taxable investment portfolio with your “bunched” charitable gifts, you can achieve multiple goals: You can reduce problem spots in your portfolio, eliminate the tax burden associated with those appreciated holdings, and of course make charitable gifts. To take advantage of this strategy, you would donate the appreciated shares directly to charity or, alternatively, use a donor-advised fund. This can be a sensible way to to lighten up on highly appreciated positions that are adding risk to your portfolio--employer stock, for example.

Strategy 3: Tax-Gain Harvesting in the 0% Capital Gains Bracket
Tax-gain harvesting is another strategy to consider if you find yourself in a year when your taxable income is at a low ebb, either in 2019 or beyond. That’s because there’s currently a 0% tax rate in place for single filers with taxable incomes below $39,375 or married couples filing jointly with taxable incomes of less than $78,750. That provides such investors with the opportunity to reduce highly appreciated or otherwise problematic positions with no tax costs, provided their total taxable incomes, including the capital gains on the sale of the security, don’t exceed the above thresholds.

In addition to not increasing their tax burdens in a given year, so-called tax-gain harvesting may prove especially advantageous for such investors if their tax brackets increase down the line. That’s because they’ve effectively washed out the taxes due on the appreciated securities by selling at a time when doing so didn’t entail tax costs. If they deploy the funds into another position in their portfolios (or even reinvest in the same holdings they sold), they’ve reset their cost basis to today’s higher levels. If they eventually bust out of the 0% bracket and owe capital gains taxes, their tax burden will be calculated off of the new, higher cost basis.

Strategy 4: Reinvesting Dividend or Capital Gains Distributions Into Underweight Positions 
Last but not least, if you have taxable positions you’d like to lighten up on without incurring major tax costs, it’s wise to consider not reinvesting your dividends and capital gains back into problematic or overweight holdings that are making the distributions. Instead, you can direct the amount of the distributions into holdings you’d rather add to, effectively using the distributions to correct your portfolio’s positioning. 

That’s particularly relevant as the fourth-quarter capital gains distributions season is nearly upon us, and the very same holdings that you might like to lighten up on to reduce your portfolio’s risk levels, such as growth-oriented stocks and funds, are the most likely to be making big capital gains distributions. Reinvesting capital gains or redeploying them into other positions is a wash from a tax standpoint, meaning that redeploying those payouts into other holdings is a (relatively) tax-efficient way to improve the positioning of your taxable portfolio.

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.