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Implementing a Fresh Portfolio? Don’t Forget About Taxes

It may be tempting to undertake a dramatic makeover, but an incremental, forward-looking approach is best for taxable accounts.

Have you ever been reading about an investment approach and thought: “This just makes sense”?

Maybe it’s an all-index-fund, all-exchange-traded-fund portfolio: You’re compelled by the data about index fund performance, and you’d like to implement a lower-cost, more tax-friendly mix. Perhaps you’re getting ready to retire and you’re attracted to a bucket strategy or maybe you’ve decided that you want to give your portfolio a makeover with environmental, social, and governance concerns in mind.

But the investment views you have now may be relatively new, and one's needs change, too: A bucket portfolio wouldn’t make sense for someone with many years until retirement; it’s only attractive if you’re actively in drawdown mode. That means that if you’d like to put a new portfolio in place, there’s going to be something you’ll have to undo. And the longer you’ve been investing, the more complicated it’s likely going to be to get your new investment mix up and running.

Of course, if your assets are all in tax-sheltered accounts, you should feel free to give your portfolio a makeover straightaway. After all, the IRS isn’t keeping tabs on any changes you make in those accounts as long as your assets remain inside of them. The only tax bills you pay will be upon withdrawal from tax-deferred accounts, not any portfolio changes you made before you pulled the money out.

But what if you already have a well-entrenched portfolio that includes taxable holdings as well as tax-sheltered? In that case, you need to be a lot more careful as you undertake your taxable portfolio's repositioning. That’s because getting the portfolio you really want is apt to entail at least some taxes as you sell taxable holdings that have appreciated. And at this late stage in the bull market, even holdings you aren’t thrilled with likely have made gains. Thus, while it might be tempting to just rip off the bandage and implement the portfolio you really want, it’s wise to take a more systematic and likely incremental, multiyear approach to changing up your taxable accounts.

Here are the key steps to take as you make over your taxable portfolio to ensure that you’re not paying more in taxes than you need to on the road to getting the portfolio you really want.

Step 1: Consider your tax bracket for capital gains. The first step is to take stock of your current tax bracket for both short-term and long-term capital gains. Gains on any securities you've held for less than one year count as short-term, meaning they're taxed at your ordinary income tax rate. Gains on securities held for longer than a year receive the more favorable long-term capital gains tax treatment. Generally speaking, unless you have an urgent investment reason to unload a security, it's beneficial to hang on so that you can pay taxes on any sales at the long-term rate rather than short-term.

Most investors will pay long-term capital gains tax of 15%; higher-income folks will pay a 20% rate. Yet it’s worth noting that investors with lower levels of taxable income qualify for the 0% tax rate on long-term capital gains. In 2020, the thresholds are nice, round numbers: Single filers with incomes of less than $40,000 qualify for the 0% rate, and it's $80,000 for married couples filing jointly. Those numbers will increase slightly next year--to $40,400 for singles and $80,800 for marrieds filing jointly.

However, it's important to point out that those income thresholds are inclusive of any capital gains you've realized during the year. In other words, realizing capital gains will jack up your taxable income, so just because your ordinary income falls under the threshold for 0% tax on long-term capital gains, you're not able to realize an unlimited amount of capital gains at a 0% rate.

That said, new retirees may find themselves with a lot of control over their incomes, and in turn their tax rates, especially because they’re not typically contending with RMDs yet. Moreover, the pandemic has pushed down many people’s taxable income levels in 2020, due to job losses, business struggles, and the pause on required minimum distributions for people over age 72. Thus, the 0% rate may not be completely out of reach, especially this year.

Step 2: Consider your cost basis. Next, check the cost basis of your current holdings--the amount that you paid for shares in your taxable accounts, adjusted upward for reinvested dividends and capital gains as well as any commissions you paid for the transaction.

The difference between your cost basis and the sale price will be the amount that is taxed at the capital gains rates discussed above. To use a simple example, let’s say Felicia put $10,000 into Fidelity Contrafund in her taxable account 10 years ago; her holdings are now worth $47,535. Assuming she’s in the 15% tax bracket for long-term capital gains, she’d owe $5,630 to sell out altogether--15% of her $37,535 gain.

Unfortunately, things aren’t usually that straightforward when it comes to cost basis. For one thing, you may not have made all of your purchases in one fell swoop; you may have instead purchased several different lots of a fund, ETF, or stock, at several different price points. In that case, you can choose from a few different methods of accounting for your cost basis. Averaging--available for mutual funds--is simplest; it averages together all of your different purchase prices. But specific share identification, which allows you to cherry-pick specific lots to sell, tends to be the most advantageous from a tax standpoint. For example, you could sell the shares that you purchased at a higher price than they’re trading today but leave the shares that are trading well above their purchase price alone. (If you've used the averaging method when you've sold shares in the past, you can't switch into another method.)

Additionally, for purchases you’ve made over the past eight to 10 years, your investment provider should have a record. Brokerage firms and fund companies began to be responsible for tracking cost basis for their clients early last decade; securities purchased since then will often be marked as “covered” in your account data on your investment provider’s website. But if you’ve held securities for longer than that (“uncovered), you’ll need to look back into your records for documentation of your cost basis.

Step 3: Scout around for losing positions. At this late stage in the bull market, it's a good bet that many of your holdings have experienced strong gains over your holding period. Heck, even many bond funds have experienced capital gains thanks to the long decline in yields, which pushes up bond prices.

That said, the market hasn’t lifted every boat and you may be able to identify some holdings in your portfolio that are trading below your cost basis. Identifying those losing positions--either whole positions or specific lots that you’ve purchased, if you’re using the specific share identification method of accounting for your cost basis--can be extremely helpful as you undertake a portfolio makeover. Among the holdings that may be underwater include energy stocks and funds, commodities investments, or small-cap value funds purchased within the past five years.

Selling and realizing losses in these holdings--assuming you wanted to sell them anyway as part of your portfolio makeover--will help offset any gains you realize elsewhere in your portfolio. Those losses can be used to offset up to $3,000 in ordinary income as well as any capital gains; unused losses can be carried forward to offset gains in future years.

Step 4: Sketch a year-by-year implementation strategy. Having gone through the preceding steps, you should be starting to develop something of a game plan for how many of these changes you can make in 2020 without triggering a big tax bill. The next step is to sketch out how you'll implement the rest of your changes in the years ahead. If you have a large-scale taxable-portfolio overhaul in mind, it may help to get some tax help before proceeding

A few key factors will affect the pace at which you’ll be able to move and the tax bill you'll incur. The first is your own expected tax rate; for example, if you’re retiring soon and expect that your early-retirement years will feature lower income than when you were working, you may have an opportunity to sell and further reposition with less of a tax bill. Market performance is also in the mix: Dramatic downward changes in the market may give you the opportunity to reposition when it’s more advantageous, taxwise, to do so. Finally, it’s also worth keeping an eye on prospective changes to the tax code: Changes to the capital gains rates have been under discussion, though it remains to be seen if we'll see changes or whether they'll be retroactive if we do.

Finally, make sure that the portfolio you're implementing is tax-friendly. For equities, the name of the game is limiting your exposure to investments that kick off a lot of dividends or capital gains. For bonds, municipal securities may make sense for investors in higher tax brackets because they escape federal tax and in some cases state and local taxes, too.

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