Keeping What You Earn:
How Tax-Efficient is Your Investment Strategy?

The idea behind tax-efficient investing is straightforward: the only profits that matter are the ones you keep. For investors, minimizing the tax bite is a significant component of an effective investment strategy. Timing is also critical: while the weeks leading up to April 15 are the most common time for tax-planning, investment-related tax strategies must have been implemented before the previous year-end to impact your current tax liability.
In this article, we describe six important strategies for tax-efficient investing and identify four “red flag” practices we have encountered over our years advising clients. Some of these ideas may be familiar while others capitalize on recent legislative changes. In all cases, for these strategies to help minimize your 2011 taxes, they must be implemented before year end. Where possible we’ve linked our recommendations to the relevant Internal Revenue Service publications or instructions for your or your tax-preparer’s reference. At Peloton, we implement customized investment strategies to optimize the tax efficiency of each client’s portfolio. We work with our clients’ tax advisors and CPAs to ensure that the investment strategy matches comprehensive tax planning efforts.

Six Strategies for Tax-Efficient Investing:

  1. Sell investments with large un-realized capital losses to offset gains. Capital losses are fully deductible against realized capital gains and are deductible against ordinary income (e.g., wages), up to $3,000 per year if losses exceed gains.There are three critical questions to consider when contemplating a tax-loss sale: 1) Do you believe the price of the investment stands a reasonable chance of intermediate term improvement? 2) What is the relative size of this investment compared to the rest of your portfolio? and 3) Are you aware of other suitable investments with appreciation potential? Depending on your answers to these questions, there are two strategies worth considering. It might make sense to sell an investment outright, realize the loss and replace it with another security which you believe is attractively valued. On the other hand, if you believe your original investment stands a good chance of appreciating in the intermediate term, and if the position is not already too large, an alternative strategy is to add to the position at the current low price and sell the original, higher-cost shares later. The key to this strategy is to wait 31 days from the second purchase before selling the original, higher cost shares. This is the holding period specified by “Wash Sale” rules to restrict the sale and near-immediate repurchase of the same security simply for the purpose of realizing a loss.
  2. When selling an investment, specify the most tax-advantageous lots. Here’s an example to illustrate this strategy: imagine that you own 500 shares of ABC, Inc., which trade at $50 per share. Suppose that you acquired those 500 shares through three different purchases: 300 shares at $40 per share; 100 shares at $45 per share; and 100 shares at $75 per share. On the total 500 share position, your average price would be $48 per share and you would have a net un-realized gain of $1,000. The tax-efficient investment strategy is to sell the 100 shares purchased at $75 per share and realize a loss of $2,500.This “specific identification” strategy has been around for a long time, so we’re amazed every time it’s not utilized! However, a recent legislative change complicates this strategy, placing a heavier burden on individual investors to identify which lots are sold. As a result of the Energy Improvement and Extension Act of 2008, brokers /custodians are required to report cost basis information on investors’ forms 1099-B and directly to the IRS. Previously, brokers were required to provide only gross sales proceeds. This change imposes a tight timeline on investors: if you want the 1099-B cost basis information to reflect your specific tax-loss sale accurately, you now must notify your broker /custodian during the three days between trade date and settlement date — or ideally when the trade order is placed.
  3. Fulfill charitable gift pledges with appreciated securities instead of cash.One tax-efficient means of making charitable gifts is to give “appreciated property” instead of cash — especially when the investment is held in a taxable account and would be subject to capital gains taxes if sold. Giving the property rather than selling it avoids realizing a capital gain, yet provides a deduction equal to the entire value of the property. The value of the gifted security can then be replenished with cash to maintain the portfolio value. Most charitable organizations maintain brokerage accounts to handle just this type of gift.The IRS imposes certain limitations on the deductibility of gifts. For gifts to most charitable organizations, a gift of appreciated property is deductible up to 30% of the donor’s adjusted gross income (AGI), whereas a gift of cash is deductible up to 50% of AGI. Apart from certain major gift decisions, though, most investors will not run into the 30% limitation.
  4. Pay investment management fees from taxable accounts. Fees paid for investment management services are tax-deductible, subject to the IRS limitations for Miscellaneous Deductions.Generally speaking, investment management fees, custodial fees and trustee fees, as well as tax preparation fees and certain un-reimbursed expenses incurred as an employee of a business, are deductible when the total of these fees is greater than 2% of your AGI.However, investors are not able to deduct investment management fees paid directly from tax-deferred accounts. To maximize the current benefit of the Miscellaneous Itemized Deduction and to keep as much money growing tax-deferred as possible, fees should be paid with after-tax dollars, wherever possible.
  5. Structure portfolios to meet income and liquidity requirements without forcing untimely asset sales. For investors who rely on their investments to meet current living expenses, focusing too much on absolute return and not enough on portfolio structuring can be devastating. As we’ve written before, investments should be used for the unique needs they satisfy. Stocks, on average, provide higher returns than bonds, which, in turn, provide higher returns than cash. However, being forced to sell stocks during periods where values are depressed can cause painful unintended consequences. Selling stocks simply to provide liquidity not only subjects a long-term investment to short-term volatility, it also increases transactions costs (trading commissions) and undermines any positive fundamental rationale for owning the stock. In taxable accounts, these “liquidity-forced” sales are taxable events and may complicate capital gains planning and/or create the need for more unnecessary activity and cost.Instead, portfolios should be structured to provide tax-efficient income to meet as much of the current expenses as possible. While interest from corporate and U.S. government bonds is taxed as ordinary income, interest from municipal securities is generally tax-free at the federal level. As well, given the extraordinarily low interest rate environment, dividend income has become increasingly attractive, with many companies’ common stocks yielding 3, 4, or 5%. These dividends are currently taxed at the maximum long-term capital gains rate of 15%. Finally, dividends on some preferred stocks, which generally offer higher yields than common stocks, are also currently taxed at 15%.
  6. Maximize pre-tax contributions to 401(k) / 403(b) retirement savings plans. For investors who are still working, this well-known strategy is among the best tax-efficient investing options available. It’s an obvious one, but worth re-stating nonetheless.

Beware of Questionable Tax-Efficient Investing Advice:

Certain tax-efficient investing practices raise red flags in our minds. Here’s a brief list which should give you pause and why:

  1. Placing an annuity inside an IRA. Annuities are themselves tax-deferred investment products. This “belt and suspenders” tactic is mostly employed by advisors who earn generous commissions on annuity sales.
  2. Assuming municipal bonds are always the best answer for high net-worth investors. Municipal bond interest is exempt from federal tax — which means that “muni” bonds are usually appropriate for investors in high marginal tax brackets. Frequently, though, investors with large investment portfolios would benefit more from taxable income — particularly if that income includes dividends. When municipal bonds are considered, investors should also be mindful of the potential alternative minimum tax (AMT) consequences of certain types of muni bonds.
  3. Avoiding wash sale rules through mutual fund share class swaps. This practice is somewhat technical but worth noting. The operative wording in wash sales restrictions is “substantially identical stock or securities.” This means that after selling ABC Corp. stock, if you buy back ABC Corp. stock within 30 days of the sale, your realized loss is not deductible. Certain advisors advocate switching between the various share classes of a single mutual fund (e.g., A shares, institutional class shares, or R shares) to get around the wash sale limits. This practice would certainly invite scrutiny from auditors, and it’s one we recommend steering clear of.
  4. Letting the tax “tail” wag the investment strategy “dog.” We generally avoid realizing short-term taxable gains. But, in the end, being overly focused on tax planning tactics — like waiting to sell a stock which has reached its price objective simply because the gain would be short-term — can jeopardize an investment plan. The tax implications of any decision should always be considered, but investing decisions should ultimately be made on the merits of the investment itself.

At Peloton we strive to achieve the optimal level of after-tax returns by carefully considering all tax aspects of a client’s portfolio. Implementing tax-efficient investing practices is one important means of keeping more of what you earn. But integrating these practices into a coherent strategy can become complex. Peloton Wealth Strategists exists to help investors design, implement and manage investment strategies which precisely fit their unique needs.
For a complementary investment consultation, we invite you to contact us.
About Peloton Wealth Strategists
Founded in 1984, Peloton Wealth Strategists is an independent, fee-only Registered Investment Advisor with a rich tradition of highly individualized plans and personal service. We serve clients throughout the United States and internationally with minimum investment assets of $1.0 million. Independence, ethics and fundamental securities analysis are at the heart of everything we do. Throughout Peloton’s history we have developed a process-oriented approach that balances the art and science of portfolio management. Peloton is not affiliated with a brokerage, insurance company or other securities firm, and our fully integrated approach to investment management provides the right structure for every client. For more information, go to