Dec 13, 2022
Year-end tax planning is like holiday dinner planning
As the year comes to an end, many people anticipate the holidays and the family gatherings to come. If you’ve ever hosted a holiday dinner, it seems like no matter how well you plan, something goes awry—forgotten bread, undercooked turkey or an unexpected guest.
Year-end tax planning can be a lot like holiday dinners. You spend much of the year not thinking about it, and as it draws near, you get more anxious about trying to get everything done right. Like holiday dinners, there’s a degree of uncertainty in tax planning; some things you can control and other things you cannot. Here are three major investment-related tax planning tools you can control: asset location, tax-loss harvesting and avoiding year-end capital gain distributions.
Tool 1: Asset location
Where you invest your assets is an important part of building a tax-efficient portfolio. Investors who own different account types, such as IRAs, Roth IRAs or taxable accounts, have the opportunity to diversify how their investments are taxed. Asset location can be effective because some assets make large distributions in the form of either ordinary income or capital gains. Depending on your situation, buying funds that make large ordinary income or capital gain distributions might be better suited for a qualified account (IRAs, 401ks, etc.) than a taxable account. Funds that make these distributions are likely not doing it because they’re poor funds. They generally make distributions because the underlying asset class is more prone to pay out those distributions.
Real estate is a good example, as most of the distributions are considered ordinary income. In fact, income is one of the largest sources of return in real estate. By investing in real estate in a qualified account, you defer having to pay tax on the ordinary income until you start drawing down on that account. Depending on tax rates, your return might be improved because you defer paying tax for a later time. In my opinion, asset location is a great year-end tax planning tool to try and squeeze extra return from the same asset.
Tool 2: Tax-loss harvesting
When you sell positions in your portfolio at a net loss, typically to help offset the potential tax impact of capital gains, it’s known as tax-loss harvesting.1 It’s also a process that should occur throughout the year instead of just at the end. Loss harvesting doesn’t necessarily mean completely forgoing the exposure you built. Consider a portfolio that holds an oil company currently in a loss position. You might want to realize the capital loss, but you don’t want to lose your exposure to oil. One solution would be to sell this oil company and buy another oil company with similar characteristics. Doing this means you get to realize the loss and keep your oil exposure. To avoid the “wash sale” rule, you must wait at least 30 days to rebuy the oil company you sold.2
It’s important to seek opportunities on an ongoing basis to realize losses. Only looking at the end of the year ignores the variation in stock prices throughout the year. Frequently reviewing the portfolio for loss-harvesting opportunities and taking advantage of them can potentially improve the after-tax return of your portfolio.
Tool 3: Capital gain distributions
Capital gains are usually triggered when you sell an investment at a higher value than when you purchased it. Mutual funds, however, can trigger capital gains even if you don’t sell the fund. This is because mutual funds are required to pass the gains they realize to their investors in the form of capital gain distributions.3 There are limited ways to avoid them, but, in my view, some of the best ways to do so are to avoid tax-inefficient funds, sell your fund before the distribution or use exchange-traded funds (ETFs) where possible.
Funds can be tax inefficient for a variety of reasons, but one example is if their investment strategy involves high turnover, which means a lot of buying and selling. You might see this in funds that are usually the more aggressive type and are trying to keep their desired exposures. For example, a growth-oriented fund might sell a stock if its performance wanes. If this happens often, and the fund has nothing to offset any gains, a year-end capital gain distribution may be made.
Most capital gain distributions occur at the end of the year and are announced ahead of time. This lead time allows investors to find ways to avoid these distributions. Advisors might often sell mutual funds ahead of time if a client holds a fund at a loss and if this fund is expected to make a capital gain distribution. Much like the aforementioned example of loss harvesting an oil company, advisors might use the proceeds of a mutual fund sale to buy another similar fund to keep the desired exposure. After 30 days, an advisor may even buy back the fund that had been sold at a loss.
Lastly, to avoid capital gain distributions, advisors may use an ETF equivalent to their preferred funds where possible. ETFs tend to make minimal capital gain distributions relative to mutual funds.4
Take advantage of professional management and advice
These are just three examples of investment-related year-end tax planning items to consider. The good news is our clients don’t need to worry about any of these—so they can focus on things like getting that holiday dinner just right. By making asset location decisions, we might have the opportunity to squeeze more return from the same asset. In our view, this is more consistent with how stock prices tend to move. A stock could’ve been down all year, but in December, it’s no longer in a loss position. As a result, the opportunity disappears to realize that loss at some point during the year.
As always, we encourage you to keep us apprised of changes or potential changes in your circumstances, however small you may think they are. Our financial planning and investment professionals are your trusted resource in partnering for financial well-being.
1 https://www.investopedia.com/terms/t/taxgainlossharvesting.asp
2 https://www.investopedia.com/terms/w/washsalerule.asp
3 https://www.investopedia.com/terms/c/capitalgainsdistribution.asp
4 https://www.investopedia.com/articles/exchangetradedfunds/08/etf-mutual-fund-difference.asp
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