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Category:
Published: February 2008
After Tax Returns
As we close out another year and begin a new one, it is a good time to review investment portfolios. It is also a good idea to examine the portfolio with an eye towards income taxes. How well a portfolio performs after factoring income taxes, may change your opinion about your portfolios performance. Ben Franklin was right about the certainty of death and taxes, but how much one actually will have to pay has been anything but certain. Over the past several decades, there have been tremendous swings in the top rates for both capital gains and ordinary income tax rates. While there have been decreases in the tax rates in the recent past, the current code is to begin to sunset in 2008 with major changes set to happen over the next several years. Once this happens, it is unclear what the new tax structure and rules will look like. In fact, it is likely that the tax code will change as soon as we enter a new presidential campaign and we have a new President in 2009.
When deciding about an investment portfolio, the tax code needs to be considered for taxable investments, but the individual circumstances of the investor must also be considered. Tax-efficient management also requires diligent monitoring of the consequences of every investment decision, as well as constant awareness of long and short-term goals. As an example, when an investment is sold can make the difference between paying the higher taxes associated with a short-term gain or the more modest tax rate of a long-term gain; this difference can be made in as little as a day. The current tax code provides maximum tax rates for capital gains if the investment is held for more than one year. Also, the current tax code provides maximum rates for qualified dividends; these rates may be lower than your ordinary income rates. Some accounts may have no choice but to incur tax costs if the gain cannot be deferred.
Of course, the simplest form of tax deferral would appear to be using a retirement account, such as a 401K or an IRA. There is also the value of tax-free municipal bonds in an investment account, which can be owned in taxable accounts. But not all assets are IRA or tax deferred accounts, and some investors require more growth than can be found in municipal tax-free bonds.
Since a large portion of assets are in taxable accounts, a full range of tactics to enhance after-tax returns must be analyzed. This involves the painstaking work of grinding out a little more return every day, sometimes at a fraction of a percentage point at a time, through attention to detail and to each clients tax situation. This is done by adhering to the following principles: avoid taking short-term gains if possible; defer realizing long-term gains if appropriate; consider cost basis and tax rate; account for individual circumstances in decisions; offset gains with losses when applicable; and avoid trades if not warranted. While many of these principles are well-known, implementing them on a daily basis is a complicated matter.
Tax management is a complicated process, with each investor presenting a unique set of circumstances involving many variables, some more ascertainable than others. The type of account must be considered, as well as the tax rate of the investor and, of course, the goals and objectives of the investor. This process requires astute attention, thoughtfulness, and expertise, and when executed properly can result in higher after-tax returns. Tax-efficient portfolio management is a complicated process that involves constant effort and long-term planning.
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