Taxes are an important factor for both your investment portfolio, and for your overall financial plan.  From an investment standpoint, it is necessary to view your investment returns on an after-tax basis.  For example, it is much better for $100 investment to receive a $10 return and a $2 tax for an after-tax return of $8 than for a $6 return and a $1 tax for an after-tax return of $5.   Minimizing taxes in this case also minimizes returns and ending wealth.  Ultimately, you are concerned about the value of your portfolio on an after-tax basis.  From an investment perspective, Tax Location and Tax Loss Harvesting are two key considerations.

Tax Location:  As investors begin investing, there is a particular need to consider “tax location” for your long-term holdings.  Put simply, there is a need to consider which assets should be held in taxable accounts, and which assets should be held in tax-advantaged accounts (like 401ks, 403Bs, IRAs, etc.)  These accounts are sometimes referred to as “qualified” accounts because they constitute a qualified employment-based retirement plan.  The objective is to maximize ending after-tax wealth.  Conventional wisdom from financial planners often structures portfolios so that fixed income assets are held in the tax-advantaged accounts so that taxes on the interest income at the ordinary income tax rate is deferred as far as possible into the future.  In addition, the equity assets are held in taxable accounts where they are subject to generally lower capital gains tax rates.  The rationale is to shelter the assets with the highest tax rates by keeping them in the Tax-Advantaged Accounts-TAA, and holding the assets with the lowest tax rates in the taxable accounts.  This sounds fine in theory, but real world investment considerations require significant adjustments.

First, your overall investment objective is most critical, and the appropriate risk/return mix takes precedence over Tax rates.  The overall Bucket 3 Investment Objective likely mandates a different mix of equity and fixed income than the holdings you have in taxable and tax-advantaged accounts.  For example, your long-term Investment Objective may be 80% equities and 20% fixed income, but you have 80% of your assets in tax-advantaged accounts.  In this case, you would put your fixed income in the tax-advantaged accounts, but you would also need to put some equity in the Tax Advantaged Accounts.

Second, for the equity portion that goes into the Tax Advantaged Accounts, it makes sense to put the assets that are most likely to generate taxable income.  Examples include actively managed mutual funds where there is significant portfolio turnover, commodity funds, Real Estate, alternative investments.

Third, index-based equity mutual funds and ETFS are best held in the taxable accounts.  These holdings generate a lower level of income, and they have lower capital gains distributions due to low trading/turnover.

Fourth, for investors with higher tax rates, municipal bonds can comprise a significant part of the fixed income allocation, and these bonds obviously belong in taxable accounts.  Interest income from these bonds is exempt from federal tax.  Interest income is exempt from state tax as well if the municipal bonds were issued in your state.

Fifth, Utilize ETFs instead of mutual funds in taxable accounts wherever possible.  The reason is that ETFs have significantly less capital gains distributions than mutual funds.


Tax Loss Harvesting:  Tax Loss Harvesting is a technique to offset investments with a loss against investments with gains so that investment portfolio taxes are reduced.  To the extent that there are investment losses, the IRS allows a deduction of up to $3,000 against your ordinary income tax rate.  It is important to note that the Long-term capital gains rate is 0% for individuals in the 10 and 15% brackets.  For those in higher tax brackets (see below), there is a benefit to waiting at least a year to receive the long-term capital gains rate, and then to offsetting losses against gains.

When doing Tax Loss Harvesting, it is important to remember the Wash Sale Rule.  The Wash Sale Rule prohibits taxpayers from selling shares to record a loss, and then reacquiring substantially identical stock or options within 30 days of that loss.

Some key points to remember:

-Recognize capital gains to the extent of the 0% capital gains tax bracket.

-Avoid short-term gains which are taxed at the ordinary income tax rate.

-Recognize losses up to the $3,000 in excess of realized gains.

-Losses exceeding $3,000 can be carried over to future years.

Taxes on Long-Term Capital Gains and Qualified Dividend Rates:

Tax Rate on 10 and 15% brackets:  0%.

Tax Rate on 25% and 35% brackets:  15%.

Tax Rate on 39.6% Bracket*:  20%.

*+ 3.8% Net Investment Income Tax if Modified AGI > $250,000.  (So marginal rate = 23.8%)

Tax Advice:  Taxes and tax planning can be extremely complex and require the expertise of a tax advisor.  Cornerstone can recommend a tax advisor.