BP Holdings Tax Management – This post was written by Jim
O'Shaughnessy, chairman, CEO and CIO at O'Shaughnessy Asset Management and by
Scott Bartone, principal and portfolio manager at O'Shaughnessy Asset
Management.
Thank heaven, tax season is over for
now. Time to put taxes in the back of your mind until next year, right? Well actually, no, not if you want to reduce
taxes paid on your investments next year.
There are tactics that you can start using today to help minimize your
tax bill in 2015.
The
Problem
Taxes can significantly erode
investment returns if an individual investor or money manager is not accounting
for them. Since short-term gains are
taxed at a higher rate than long-term gains or qualified dividends, it is better
to avoid triggering short-term gains if you can’t offset those gains with
short-term losses. Look at the
hypothetical portfolio assumptions in the table below. In this year, 50% of the positions were sold
at some point, creating taxable impact.
What the table below tells us is that while taxes can detract from
returns, we can mitigate their impact by paying attention to whether we sell
the positions at a gain or loss, and whether those gains or losses are short or
long-term. We believe that smart and
disciplined management does add value over just holding passive ETFs, but smart
tax management is a key factor in any strategy.
What
You Can Do to Minimize Your Tax Bill
Rather than simply waiting until the
end of the year to sell losing positions, tax management is something that
should be done throughout the year and should be incorporated into your
investment strategy. By waiting until
the end of the year to sell off your losers, you will likely drift away from
your investment strategy. What’s more,
you’ll likely not be the only one selling off losers at year’s end, and this
negative momentum could push prices down further.
The better plan is to remain invested
in your strategy and review your cost basis any time you are looking to
trade. Reviewing your unrealized gains
and losses throughout the year—rather than just the year’s end—will give you
more “point in time” observations and more opportunities to harvest in your
portfolio. If you have a well-diversified
portfolio (as you should!), there are likely stocks that are at a loss
throughout the year. Look at the S&P
500 over the past five years. If you
only review it on an annual basis you only see positive returns, making it
difficult to realize offsetting losses.
However, if we look at returns on a monthly basis, we see that in 18 of
60 months, the S&P 500 had negative returns, and some of them were
significant. Even in years when the
S&P 500 has strong returns, there are always inflection points when markets
turn downward. To offset gains for tax
purposes, investors should take advantage of these periods to realize some
losses in their portfolios.
Here's
four techniques to use throughout the year:
1. Defer
the realization of taxable gains until they go long term – Whenever
possible, restrict the sale of a stock that is in a short-term gain position so
as not to impose the higher short-term tax rate. It is often worth delaying the sale of a
winning position until you have owned it for more than a year, since the
difference in tax rates is substantial.
The short-term tax rate is almost 20% higher (for top earners), so even
if your investment has negative performance until it goes long term, you still
may end up with more money on an after-tax basis then if you had sold it short
term.
2. Target
short-term losses within the portfolio to sell – Review your portfolio
throughout the year and seek to strategically target sell short-term losses so
you can use these as an offset.
Short-term losses can foil short-term gains that you may have earned
across your other investments. If you
still have short-term losses after you have netted out your short-term gains,
you can then use those losses against your long-term gains. Finally, if there are still losses left, you
can use them as a carry-forward to future tax years. Again, doing this throughout the year rather
than just at the end of the year will give you more chances to find losses in
your portfolio.
3. Avoid
wash sales when possible – In order to realize the tax benefit of realizing
a loss, wash sale rules must be obeyed.
A wash sale occurs when a stock is sold at a loss, and within 30 days
before or after sale, you also purchase the same stock. Should a wash sale trigger, you will not be
able to apply losses as an offset.
4. Gifting
Securities – If you have a charity that is near and dear to you, gifting a
security that has had significant gains can be a way to give to a good cause
and also help your tax bill. By gifting
shares that you have held for longer than a year, you can avoid paying taxes on
the gains and can also claim the full market value of the shares gifted as a
charitable deduction at the end of the year.
Consult the charity of your choice to see if they have a mechanism in
place to receive security gifts.
Take the time throughout the year to
look at where your portfolio is positioned -
If you have generated significant gains throughout the year or think you
will, look for opportunities to sell losses within your portfolio. Taxes can be a significant drag on returns
for individual investors. You should
apply the same rigor to both your investment strategy and your tax strategy to
maximize your portfolio’s net performance.
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