Guidance

RESOURCES TO HELP SHAPE YOUR FINANCIAL FUTURE

When it comes to investment management, a policy of benign neglect is often better than a too-active one. Yet even hands-off investors should consider changes once in a while. A portfolio’s asset mix can shift over time—sometimes substantially. Your appetite for risk may change. Sometime, account types that made sense for you at one life stage may no longer fit. Whatever the reason, adjustments to your portfolio will often have tax consequences. 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 have experienced for the past decade.

If you are considering potential changes you would 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
After 10-plus years into a bull market it is easy to make the case that many investors need to rebalance. While bonds have also performed fairly well, a portfolio that was 80% S&P 500 and 20% Bloomberg Barclays U.S. Aggregate Bond Index would be more than 90% equity today. Meanwhile, a 60% equity and 40% bond blend 10 years ago would be more than 80% equity now.

Younger investors might reasonably continue to hold an equity-heavy mix. 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 do not and the market tumbles, they could be forced to draw upon depreciated equity assets for living expenses.

This is a classic case where doing what is right for your portfolio can be all wrong for your tax bill. If you lighten up on appreciated holdings in your taxable accounts, you will owe capital gains taxes on the appreciation. Meanwhile, rebalancing your tax-sheltered accounts, where you may well hold the bulk of your money anyway, will not entail tax consequences as long as the funds stay 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, as opposed to selling.

Not Taking Advantage of 0% Rate for Capital Gains
A hands-off approach to taxable holdings is not always warranted, 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 have 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 is 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 are 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 have repurchased it, you may be able to take a tax loss.

Not Exercising Caution on Conversions
Tax issues related to a bull market are not the exclusive domain of taxable investors. Investors considering a conversion from a Traditional IRA to a Roth may find that a lofty market is a less opportune time to do so than a weak one. That is because the taxes due upon the conversion depend on the current balance, less any monies that have already paid toward taxes, such as nondeductible IRA contributions. With balances up, the conversion-related tax bills will be, as well.

That is why it is so valuable to work with a professional 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.

Resigning Yourself to Big Tax Bills Related to Your Mutual Funds
Finally, you might assume that big capital gains distributions are just the cost of making money: While selling before a distribution may help you avoid 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 run.

If you own a fund that has been a “serial distributor” of capital gains—and funds have made some significant in recent years—and you reinvested the distributions and paid taxes on them, you have essentially already prepaid some of the taxes that you will owe when you sell your shares. Thus, it is a mistake to assume that you are 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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