In today’s low yield and high tax environment, every dollar counts. That’s why constructing the most tax efficient, low cost and diversified portfolio is essential. Even if you’re seeing excellent pre-tax returns in your portfolio, it doesn’t mean much if it evaporates on an after tax basis.
Let’s take a look at an example. The chart below shows the impact of a 1% annual tax “cost” on a $100,000 portfolio. We see the portfolio grow at an 8% annualized return over ten years. At 0% tax costs, the portfolio balance would have grown to nearly $216,000 at the end of the decade. But, with a 1% tax cost, the investor has an out of pocket expense of more than $20,000 over the same period.
So how realistic is this example? A 1% tax cost is pretty comparable, as the long-term average annual tax cost for stock mutual funds over the last ten years was 0.9%. The average annual tax cost for bond funds over the same period was 1.6%.**
Given those real costs, it can really pay to plan ahead for your tax bill. Here are 5 things you can do going into yearend to reduce your 2014 tax bill:
- Check your portfolio to see where you might be hit with a capital gain distribution. Fund companies generally post estimates on their websites in November. If you find your fund is about to pay a capital gain distribution, and you were otherwise considering a change (such as shifting your asset allocation, or for performance or loss harvesting reasons) consider getting out before the gain is paid in December. Then reposition into a more tax-efficient fund.
- Check your portfolio to see where you can harvest losses. Your tax bill is determined according to you overall gains and losses, so taking a loss on one investment to reduce your total taxable gains can really help.
- See if it makes sense to donate securities. When you donate appreciated stocks to charity, you don’t have to pay taxes on your gains, and the charity doesn’t have to pay them, either. Plus, you can deduct the total market value of the securities (not just your original investment), which reduces your total taxable income. Keep in mind this would only make sense to do if you have an unrealized gain. Securities with unrealized losses should generally not be used this way, because the potential to offset to future tax liability would be forfeited.
- Non-cash donations not accepted? Try a donor advised fund. If your charity of choice doesn’t accept stocks, you can inquire about a donor advised fund, which is a separate account maintained by a charitable organization.
- Max out your retirement account contributions. Make sure you’ve contributed all you can to your 401(k) or IRA. The 2014 contribution limit for a 401(k) is $17,500, with a catch up contribution limit of $5,500 for those age 50 or older, while the limit for a SIMPLE IRA is $12,000 with a catch-up limit of $2,500.
Another great way to employ the best strategy for your portfolio: discuss your options with a tax advisor.