January 31, 2018
If there is a universal investment ideal, it is this: Every investor wants to buy low and sell high. What if we told you there is a disciplined process for doing just that, and staying on track toward your personal goals while you’re at it? Guess what? There is. It’s called rebalancing.
Rebalancing: How It Works
Imagine it’s the first day of your investment experience. As you create your new portfolio, it’s best if you do so according to a personalized plan that prescribes how much weight you want to give to each asset class. So much to stocks, so much to bonds … and so on. Assigning these weights is called asset allocation.
Then time passes. As the markets shift around, your investments stray from their original allocations. That means you’re no longer invested according to plan, even if you’ve done nothing at all; you’re now taking on higher or lower market risks and expected rewards than you originally intended. Unless your plans have changed, your portfolio needs some attention.
This is what rebalancing is for: to shift your assets back to their intended, long-term allocations.
A Rebalancing Illustration
To illustrate, imagine you (or your advisor) has planned for your portfolio to be exposed to the stock and bond markets in a 50/50 mix. If stocks outperform bonds, you end up with too many stocks relative to bonds, until you’re no longer at your intended, balanced blend. To rebalance your portfolio, you can sell some of the now-overweight stocks, and use the proceeds to buy bonds that have become underrepresented, until you’re back at or near your desired mix. Another strategy is to use any new money you are adding to your portfolio anyway, to buy more of whatever is underweight at the time.
Either way, did you catch what just happened? Not only are you keeping your portfolio on track toward your goals, but you’re buying low (underweight holdings) and selling high (overweight holdings). Better yet, the trades are not a matter of random guesswork or emotional reactions. The feat is accomplished according to your carefully crafted, customized plan.
Portfolio Balancing: A Closer Look
In reality, rebalancing is more complicated, because asset allocation is completed on several levels. First, we suggest balancing your stocks versus bonds, reflecting your need to take on market risk in exchange for expected returns. Then we typically divide these assets among stock and bond subcategories, again according to your unique financial goals. For example, you can assign percentages of your stocks to small- vs. large-company and value vs. growth firms, and further divide these among international, U.S., and/or emerging markets.
One reason for these relatively precise allocations is to maximize your exposure to the right amount of expected market premiums for your personal goals, while minimizing the market risks involved by diversifying those risks around the globe and across sources of returns that don’t always move in tandem with one another. We are guided by these tenets of evidence-based investing.
Striking a Rebalancing Balance
Rebalancing using evidence-based investment strategies is integral to helping you succeed as an investor. But like any power tool, it should be used with care and understanding.
It’s scary to do in real time. Everyone understands the logic of buying low and selling high. But when it’s time to rebalance, your emotions make it easier said than done. To illustrate, consider these real-life scenarios.
- When markets are down: Bad times in the market can represent good times for rebalancing. But that means you must sell some of your assets that have been doing okay and buy the unpopular ones. The Great Recession of 2007–2009 is a good example. To rebalance then, you had to sell some of your safe-harbor holdings and buy stocks, even as popular opinion was screaming that stocks were dead. Of course history has shown otherwise; those who did rebalance were best positioned to capture available returns during the subsequent recovery. But at the time, it represented a huge leap of faith in the academic evidence indicating that our capital markets would probably prevail.
- When markets are up. An exuberant market can be another rebalancing opportunity – and another challenge – as you must sell some of your high flyers (selling high) and rebalance into the lonesome losers (buying low). At the time, this can feel counterintuitive. But disciplined rebalancing offers a rational approach to securing some of your past gains, managing your future risk exposure, and remaining invested as planned, for capturing future expected gains over the long-run.
Costs must be considered. Besides combatting your emotions, there are practical concerns. If trading were free, you could rebalance your portfolio daily with precision. In reality, trading incurs fees and potential tax liabilities. To achieve a reasonable middle ground, it’s best to have guidelines for when and how to cost-effectively rebalance. If you’d like to know more, we’re happy to discuss the guidelines we employ for our own rebalancing strategies.
The Rebalancing Take-Home
Rebalancing using evidence-based investment strategies makes a great deal of sense once you understand the basics. It offers objective guidelines and a clear process to help you remain on course toward your personal goals in rocky markets. It ensures you are buying low and selling high along the way. What’s not to like about that?
At the same time, rebalancing your globally diversified portfolio requires informed management, to ensure it’s being integrated consistently and cost effectively. An objective advisor also can help prevent your emotions from interfering with your reason as you implement a rebalancing plan. Helping clients periodically employ efficient portfolio rebalancing is another way we seek to add value to the investment experience.
December 29, 2017
We interrupt your busy holiday season with a quick post on last week’s U.S. tax code overhaul. While the ink still dries on this sweeping new legislation, you may be wondering whether there are ways you can or should spring into action immediately, before year-end, to reposition yourself for the new law of the land.
First, we want to emphasize that the new rules are not retroactive. Your 2017 tax return – the one due this April – will still be prepared under pre-reform law.
Practically speaking, this means there is probably not a great deal you must do right away. If we’re aware of particular circumstances in your life that might warrant otherwise, we will be in touch with you directly to assist – if we haven’t been already. And of course we remain on call as always, to promptly assist with any questions or requests you may have at your end.
In the meantime, here is our general take on how to position your year-end tax planning choices.
Do you value your limited holiday season time with loved ones far more than the potential to shave off some future tax dollars owed? If so, even if you might forgo potential savings, you might prefer to opt out of making any special tax-planning moves at this time (beyond those you’d be doing anyway).
Would you rather ensure every tax-related dollar is spared, even if it takes a little extra immediate time to do so? If that’s the case, there are at least two areas you may want to consider right away: your charitable giving habits, and the timing of your taxable income.
First, let’s talk about your charitable giving. By design, most Americans are likely to fare better in 2018 by taking the higher standard deduction available under the new law instead of itemizing deductions on Schedule A. If it’s likely you will no longer submit a Schedule A next year, then charitable contributions will no longer help you reduce your taxes.
BUT, if you’ve been itemizing in years past – i.e., submitting a Schedule A – you’ll probably still itemize in 2017. Thus there may be benefits to making your 2018 charitable contributions before year-end, when they might still “pay off” for you and your recipients alike (subject to existing limitations). You can write those checks directly. Or, this might be a good time to consider funding a Donor Advised Fund, from which you can distribute donations in the future while taking the tax break today.
One other general consideration as we approach year end: Many Americans’ tax rates are expected to decrease next year. Thus, if there are reasonable (legal) ways to shift any reportable income into 2018, you may end up paying less tax on it.
As always with tax planning, there are a ton of caveats, catches and exceptions to these rules of thumb. If you are thinking of taking action before year-end, we hope you’ll be in touch, so we can discuss the details with you. Either way, we will no doubt be having much deeper discussions in 2018 about what the new tax law means to your tax planning, your personal wealth and your lifetime goals. We look forward to being here for you – today, tomorrow and throughout the years ahead.
September 25, 2017
One of the toughest realities to prepare for after a divorce—and especially after a difficult one—is the division of financial assets. Wealth accumulated throughout a life’s hard work could be severely and negatively impacted in a matter of months, creating problems that could continue for years if the proper details are not attended to during the divorce proceedings. That is why today we will be discussing one of the most important acronyms to pay attention to during a divorce settlement: QDRO.
What Is a QDRO?
A qualified domestic relations order (QDRO) is a court order, judgment, or decree that allows a qualified retirement plan, such as a 401(k), 403(b), or pension, to pay benefits to the former spouse (or other dependent individual) in addition to the individual who controls and contributes to the plan. Without a QDRO, the alternate payee (the person assigned to share these types of benefits) is not entitled to receive any monies the plan will pay out. A QDRO agreement does not extend to include outside workplace retirement accounts such as savings/checking accounts, houses, etc.
Steps to Acquire a QDRO
Approval of a QDRO, which is finalized when the divorce itself is finalized, is generally granted before the divorce judgment is handed down. Any competent divorce attorney will know the steps needed to obtain a QDRO during the negotiation phase of a divorce.
But let’s say that a QDRO was not drafted for approval by your spouse, the retirement plan itself, or the judge during the proceedings for your divorce. This does not mean that you are out of luck. There is still a chance that you can obtain a QDRO and receive a fair portion of your now-ex-spouse’s retirement account. Here is what you need to do in order to make that happen:
- Sit down with an attorney who specializes in QDROs. Generally speaking, negotiating a QDRO during the divorce proceedings makes the division of assets easier. Once that time has passed, however, meeting with a lawyer to discuss how to obtain a QDRO will still ensure that you have the best chance to receive a post-decree settlement. The American Academy of Matrimonial Lawyers is one resource you could consider using to locate an attorney who specializes in family law which includes QDROs. It is important to lay out a clear legal plan before the proceedings.
- Send the resulting QDRO draft to the retirement/pension plan administrator. This is the most important step in the QDRO process. If the retirement/pension plan rejects your draft, you’ve wasted valuable time, which could prove costly. Oftentimes, the plan will return a copy of the draft with suggestions for changes based on the plan’s own rules and regulations. Consulting with an attorney with expertise in the QDRO process might enable you to circumvent some of these issues.
- Get the needed signatures from a judge and all affected parties. Once the retirement/pension plan has given its approval, it is important to obtain signatures from a divorce judge and all interested parties. The sooner this step is completed, the closer you will be to receiving your share of the benefits.
- Send a copy to the pension/retirement plan. Send the pension/retirement plan administrator a copy of the QDRO for approval. This will ensure that the benefits are paid out.
The steps listed above might take only a few months to complete, if everything happens quickly. Any delay, however, will mean more time before you receive the benefits, assuming all is in order. If your former spouse remarries or dies, it will become almost impossible to get any portion of the retirement account from the employer.
Divorce is one of the most difficult events a person may have to go through in life, and the aftermath of a divorce can be harder to handle if the marital assets were not divided well. A QDRO could be one of the most important financial documents obtained during this emotionally charged period of time. Seeking advice from a team of legal and financial experts will do wonders for your financial well-being and give you peace of mind.
September 1, 2017
The average price tag for four years at a private college exceeds $170,000, according to the College Board’s Trends in College Pricing 2014. That’s 17% higher than seven years previously. In fact, rising tuition costs are outpacing inflation at the same time that federal grant aid is lagging behind inflation.
While funding four years of college can be a challenge, research also proves that higher education remains a valuable investment. According to the College Board’s Education Pays 2013, in 2011, women with bachelor’s degrees earned 70% more than women with only high school diplomas; college-educated men earned 69% more than men who graduated from high school but did not have college degrees.
There are a variety of savings vehicles and planning strategies that can help you overcome the financial challenges and reach your education goals. One tax-efficient vehicle is the Coverdell Education Savings Account (ESA), which can be used to pay for college expenses, as well as for the cost of attending qualified K-12 schools.
With a Coverdell ESA, funds have the opportunity to grow tax deferred, and withdrawals used for qualified educational expenses, such as tuition, are tax free. A beneficiary can be anyone under the age of 18 (or older, if qualified as a special needs beneficiary). Any individual (including the beneficiary) may make contributions to a Coverdell ESA, as long as his or her modified adjusted gross income for the year is less than $110,000 ($220,000 for married couples filing joint tax returns). Other features include the following:
- Contribution limits are $2,000, per beneficiary, per year.
- Individuals may contribute to both a Coverdell ESA and a 529 plan for the same beneficiary, without incurring any tax penalties.
- Corporations and nonprofit groups are eligible to contribute to ESAs. Unlike individual contributors, corporations or nonprofit organizations are not subject to earning restrictions.
- Contributions can be made up to the April tax-filing deadline.
- It is permissible to claim either the American Opportunity Tax Credit or the Lifetime Learning Credit in the same year that you take a tax-free distribution from an ESA, provided the ESA distribution is not used for the same expenses for which the credit is claimed.
- In addition, distributions from ESAs may be used to fund the following qualified education expenses:
- Tuition and fees incurred by the beneficiary at any eligible educational institution, including qualified elementary and secondary schools (K-12), as well as qualified post-secondary educational institutions.
- The cost of books, supplies, and equipment, including uniforms, computers, and related technology peripherals (if the computer-related equipment and services are to be used by the beneficiary during any of the years he or she attends school).
- Room and board, if the beneficiary is enrolled at least half-time in an eligible educational institution. Room and board expenses are limited to one of the following: The school’s regular, posted room and board charges for students living on campus, or $2,500 for each year the student is living off campus, but not at home.
By expanding the definition of qualified educational expenses to include primary and secondary education expenses, as well as room and board, the Coverdell ESA is proving to be a welcome addition to the various tax-favored options for saving for educational expenses.
Note: Nonqualified distributions may be subject to an additional 10% federal tax penalty on earnings.
August 1, 2017
Many of us may perceive trusts as a complex subject better left to our attorney. However, a trust is simply a contract initiated by a grantor who agrees to transfer assets to a beneficiary, who then receives the assets as stipulated in the trust contract. A trustee, who may also be the grantor, manages the trust assets and ensures the stipulated terms of the trust are faithfully executed.
A trust is designed to help individuals manage a variety of family and tax-related estate planning concerns. Here are a few ways in which trusts can be used:
Revocable Living Trust. A revocable living trust is an estate planning trust that deeds property to an heir but allows the grantor to retain control over the property during his or her lifetime. Upon the grantor’s death, the property passes to the beneficiary, avoiding probate, which is the judicial process wherein a court appoints an executor to carry out the provisions of a will. While the revocable living trust does not provide tax savings for the grantor during his or her lifetime, the trust becomes ‘irrevocable’ upon death, and the beneficiary is then entitled to tax advantages.
Irrevocable Living Trust. An irrevocable living trust is an estate planning trust wherein the grantor does not retain control of assets or property. Through the transfer of assets or property into the trust, the grantor may be eligible for certain tax savings. An irrevocable living trust may also be used to avoid probate.
Irrevocable Life Insurance Trust (ILIT). An irrevocable life insurance trust is designed to provide tax savings through the ownership of a life insurance policy. Assets in the trust are generally not considered part of the grantor’s estate. ILITs may be funded or unfunded. With a funded ILIT, income-generating assets are transferred into the trust, and the generated income is then used to pay the premiums on the life insurance policy. With an unfunded ILIT, the grantor makes yearly gifts to the trust, and this money is then used to pay the premiums on the life insurance policy.
Credit Shelter Trust: A credit shelter trust, also called a bypass trust, is an estate planning tool used to protect assets from successive estate taxes. While current law permits an unlimited amount of assets and property to pass to a surviving spouse without being subject to Federal estate taxes, children and other beneficiaries must pay taxes for inheritances valued in excess of the applicable estate tax exclusion amount, which is $5.49 million per individual in 2017. If a married couple wishes to take advantage of a credit shelter trust, they generally arrange for certain assets to pass into the trust for the benefit of the surviving spouse, rather than passing all assets directly to the spouse. This trust, which would not be considered part of the surviving spouse’s estate—and generally does not exceed the applicable exclusion amount—may pay the surviving spouse income for life and then, upon his or her death, may pass to a beneficiary, such as a child, free of estate taxes if under the exclusion limit. In addition, the gross estate of the surviving spouse upon his or her death could pass to the same beneficiary, and up to $5.49 million in 2017 would be free of estate taxes.
Charitable Remainder Trust (CRT): A charitable remainder trust is an arrangement in which assets are donated to a charity but the grantor continues to use the property and/or receives income from it. A CRT may allow the grantor to avoid capital gains taxes on highly appreciated assets; receive an income stream based on the full, fair market value (FMV) of those assets; receive an immediate charitable deduction; and ultimately, benefit the charity of his or her choice.
Dynasty Trust: This trust is often used by individuals to pass wealth to their grandchildren free of generation-skipping transfer taxes.
A trust can be an effective way to accomplish your long-term estate planning goals, but often involve complicated tax laws. Consult with your tax and legal professionals about your particular situation and how a trust may enable you to share your wealth with family, friends, or charities.
July 12, 2017
Americans donate billions to charity annually. If you give to charity, you need to know about one of the best tools to facilitate generosity: Donor-Advised Funds (DAFs).
DAFs date from the 1930s but did not become popular until the 1990s. DAFs act as vehicles for receiving gifts, often of appreciated stock, and then distributing cash grants to charities selected by the one making the donation. DAFs make the process of transferring appreciated stock and designating checks as simple as a bank’s bill-paying system.
All DAF donors receive a tax deduction on the date of transfer. You can also transfer stock during one calendar year and receive a deduction even if the DAF completes distribution of grant money to a charity in a subsequent year. According to Internal Revenue Service rules, you calculate the value of your donation and the resulting fixed deduction based on the average of the high and the low market price on the day of transfer. (You are responsible for computing
After receipt, the stock you gifted is sold and the DAF, itself a charity, pays no tax on any capital gain realized. The proceeds may remain in cash or you may direct the DAF to invest those assets for potential further appreciation (usually in a professionally managed separate account). Any subsequent change in the value of the account does not change the amount you can deduct on
As the donor, you direct to which charities the DAF distributes assets. Officially, the DAF owns the assets and is not legally bound to use them as you direct, but it is exceedingly rare for a DAF to not follow the donor’s advice.
Most DAFs also maintain a database of 501(c)(3) tax-exempt charities (based on those organizations’ IRS 990 filing) from which you chose. After you suggest an amount to gift and a charity to receive the gift, the DAF vets and processes your suggestion to ensure the organization qualifies as a public charity under the IRS code. DAFs also handle all record keeping and due diligence and can protect your identity if you want to give anonymously.
Donor-advised funds are the fastest growing charitable giving vehicle in the United States, with more than 269,000 donor-advised accounts holding over $78 billion in assets. To put that in perspective, the Bill and Melinda Gates Foundation has about $39.6 billion in assets.
Besides consider a DAF, here are other ways to make your charitable giving more significant:
Focus your effort. Passionate giving is more sustainable than spreading donations to every good cause or everyone who asks. Consider focusing your donations to just a few charities. Think through why you are giving and what you feel passionate about.
Find bang for the buck. Fund programs that produce the greatest effect for the least money and focus on long-term positive outcomes.
Include the next generation. You can include your children in the giving process or even help them gift some of their own money.
Talk to Your Financial Advisor. If you’re considering a DAF or want to learn more, give Hiley Hunt Wealth Management a call so that we can walk through the process together.
November 1, 2016
So much of investing is beyond our control (picking stock prices, timing market movements and so on), it’s nice to know that there are still a number of “power tools” we can employ to potentially enhance your bottom line. Tax-loss harvesting is one such instrument … although the analogy holds true in a couple of other ways: It’s best used skillfully, and only when it is the right tool for the task.
The (Ideal) Logistics
When properly applied, tax-loss harvesting is the equivalent of turning your financial lemons into lemonade by converting market downturns into tangible tax savings. A successful tax-loss harvest lowers your tax bill, without substantially altering or impacting your long-term investment outcomes.
If you sell all or part of a position in your taxable account when it is worth less than you paid for it, this generates a realized capital loss. You can use that loss to offset capital gains and other income in the year you realize it, or you can carry it forward into future years. We can realize losses on a holding’s original shares, its reinvested dividends, or both. (There are quite a few more caveats on how to report losses, gains and other income. A tax professional should be consulted, but that’s the general premise.)
Your Greater Goals
When harvesting a loss, it’s imperative that you remain true to your existing investment plan as among the most important drivers in achieving your ultimate financial goals. To prevent a tax-loss harvest from knocking your carefully structured portfolio out of balance, we reinvest the proceeds of any tax-loss harvest sale into a similar position (but not one that is “substantially identical,” as defined by the IRS). Typically, we then return the proceeds to your original position no sooner than 31 days later (after the IRS’s “wash sale rule” period has passed).
The Tax-Loss Harvest Round Trip
In short, once the dust has settled, our goal is to have generated a substantive capital loss to report on your tax returns, without dramatically altering your market positions during or after the event. Here’s a three-step summary of the round trip typically involved:
- Sell all or part of a position in your portfolio when it is worth less than you paid for it.
- Reinvest the proceeds in a similar (not “substantially identical”) position.
- Return the proceeds to the original position no sooner than 31 days later.
An effective tax-loss harvest can contribute to your net worth by lowering your tax bills. That’s why we keep a year-round eye on potential harvesting opportunities, so we are ready to spring into action whenever market conditions and your best interests warrant it.
That said, there are several reasons that not every loss can or should be harvested. Here are a few of the most common caveats to bear in mind.
Trading costs – You shouldn’t execute a tax-loss harvest unless it is expected to generate more than enough tax savings to offset the trading costs involved. As described above, a typical tax-loss harvest calls for four trades: There’s one trade to sell the original holding and another to stay invested in the market during the waiting period dictated by the IRS’s wash sale rule. After that, there are two more trades to sell the interim holding and buy back the original position.
Market volatility – When the time comes to sell the interim holding and repurchase your original position, you ideally want to sell it for no more than it cost, lest it generate a short-term taxable gain that can negate the benefits of the harvest. We may avoid initiating a tax-loss harvest in highly volatile markets, especially if your overall investment plans might be harmed if we are unable to cost-effectively repurchase your original position when advisable.
Tax planning – While a successful tax-loss harvest shouldn’t have any impact on your long-term investment strategy, it can lower the basis of your holdings once it’s completed, which can generate higher capital gains taxes for you later on. As such, we want to carefully manage any tax-loss harvesting opportunities in concert with your larger tax-planning needs.
Asset location – Holdings in your tax-sheltered accounts (such as your IRA) don’t generate taxable gains or realized losses when sold, so we can only harvest losses from assets held in your taxable accounts.
Adding Value with Tax-Loss Harvesting
It’s never fun to endure market downturns, but they are an inherent part of nearly every investor’s journey toward accumulating new wealth. When they occur, we can sometimes soften the sting by leveraging losses to your advantage. Determining when and how to seize a tax-loss harvesting opportunity, while avoiding the obstacles involved, is one more way we seek to add value to your end returns and to your advisory relationship with us. Let us know if we can ever answer any questions about this or other tax-planning strategies you may have in mind.
December 21, 2015
As year-end nears, we hope you’ve saved time in your busy holiday schedule to pause and give thanks. At Hiley Hunt Wealth Management, we have so very much to be thankful for! To share our gratitude, we’d like to give you some thoughts. Thoughts on giving, that is.
As the London-based Charities Aid Foundation (CAF) describes it, “The impulse to give, to help others if you can, is a natural human instinct.”
It’s easy for that “data point” to get buried in the barrage of news we read to the contrary. But what if we adopt the same long-term perspective for investing and personal giving alike?
If you view our global capital markets close up and colored by the heat of the moment, it’s easy to grow disheartened and lose faith in the market’s ability to prevail. That’s why, as an investment advisor, we are forever stressing how important it is to consider your investments from a comfortable distance, through the clarifying lens of empirical evidence, and in the context of patiently participating in decades of rich – and likely enriching – human enterprise.
It might help to think about charitable giving from the same vantage point. Thanks to research-oriented organizations such as CAF, http://givingusa.org/, GivingPledge.org and many others, the evidence on our giving proclivities becomes clear, with much room for optimism to be found.
Myanmar, one of the world’s poorest nations, is also THE most generous. In its annual World Giving Index, CAF assesses “generosity” on three levels: helping strangers, donating money to a charity, and donating time to an organization. Based on its most recent data, CAF found that Myanmar ranked highest in donating both time and money, with a whopping 92 percent of those surveyed allocating a portion of their hard-earned money to charity.
Some of the world’s wealthiest families have been dedicating the majority of their wealth to philanthropy. Most recently, Mark Zuckerberg and his wife Priscilla Chan made headline news by informing their newborn daughter that they were going to pledge 99% of their Facebook shares to a giving mission, to make the world a better place for her.
GivingPledge.org has been quietly accumulating a collection of similar pledges for years from ultra-wealthy families, both famous and unknown. As Warren Buffett described in his pledge: “Were we to use more than 1% of my claim checks (Berkshire Hathaway stock certificates) on ourselves, neither our happiness nor our well-being would be enhanced. In contrast, that remaining 99% can have a huge effect on the health and welfare of others.”
Most of the rest of us appear to be doing our bit as well. For example, according to a June 2015 Giving USA press release: “Americans gave an estimated $358.38 billion to charity in 2014, surpassing the peak last seen before the Great Recession.” The figure represented the highest level of giving measured in the organization’s 60 years of reporting on it, with more than 70 percent of the donations coming straight from individual donors. Here’s to us regular folk!
Will our giving cure all that ails the world? The evidence tells us this might be a tall order indeed. But we’ll echo one of the lesser-known GivingPledge.org participants, Indian-American businessman and 5-Hour Energy mogul Manoj Bhargava: “We may not be able to affect human suffering on a grand scale but it will be fun trying.”
We wish you and yours a prosperous and fun-filled 2016.
We would love to invite you to learn more about Hiley Hunt Wealth Management and who we serve in Omaha, NE –Financial Planning and Investment Management.
July 16, 2015
In Part I of our series on Tax-Wise Investing, “You and Your Investments,” we explored how to engage in year-round tax-wise investing by adopting your own best practices as well as by favoring fund managers who are likewise keeping a tax-efficient eye on their offerings. There are two other important areas to tend to as part of your due diligence: your investment portfolio’s tax-efficient management and your advisers’ tax-efficient teamwork.
Proper Portfolio Management: The Art of Asset Location
Beyond tax-wise management of the individual funds in which you’re invested, some categories of investments are inherently more tax-efficient than others. For example, stock funds are usually more tax-efficient than bond funds (with many caveats that we won’t go into here). A plain vanilla U.S. stock fund tends to be more tax-efficient than funds seeking to capture the expected premium returns from smaller, less liquid markets. And so on.
This means that another vital way to manage your taxable income is to practice wise asset location, which is a fancy way of saying that you should place the least tax-efficient funds within your tax-sheltered retirement accounts, where the inefficiencies are more effectively rendered moot. The reverse is true for your most tax-efficient holdings. You want to keep them out of your tax-sheltered accounts, where their tax-efficient advantages are often lost.
The concept is simple enough, but implementation can be tricky. First, there is only so much room in your tax-sheltered accounts. Challenging trade-offs must be made to ensure you’re making best use of your available tax-sheltered “space.” Effective asset location also involves considering other tax-planning needs, such as the ability to harvest capital losses against capital gains, donate appreciated shares to charity, implement a step-up in basis, and take foreign tax credits. While these opportunities have more or less importance depending on your goals and circumstances, they become unavailable for stocks held in tax-sheltered accounts.
In short, arriving at – and maintaining – the best asset location formula for you and your unique circumstances is something of an art as well as a science. That’s one reason why it’s important to have a well-coordinated adviser team, to ensure that you’re making best use of all of the wealth-building opportunities available to you, including but not limited to asset location.
Organized Alliances: Do Your Advisers Get Along?
It’s important to manage your investments tax efficiently. But what about when it comes time to transfer your wealth – bequeathing it to heirs and making meaningful donations? And what about your tax filings themselves? Is your accountant aware of what your investment manager is up to, and are both of them informed of pertinent details related to your estate planning?
In short, are key members of your financial team – your estate planning attorney, investment adviser, tax professional, insurance providers and others – acting in isolation or in coordinated concert with one another? Even if each is seeking to best manage tax-related events within his or her specialized area of expertise, if there is little or no coordination among their activities, unnecessary (taxable) gaps or overlaps may occur when key communications break down.
Putting It Together: The Tax-Wise Wealth Manager
Tax-efficient investing can add considerable power to your net wealth – the kind you and your family get to keep after taxes and expenses have taken their toll. But making the most of the many opportunities can be daunting if you’re going it alone. As we’ve covered in this series, tax-wise investing includes:
- Establishing an effective Investment Policy Statement
- Making best use of available tax-sheltered or tax-free investment accounts
- Investing tax efficiently yourself
- Selecting fund managers who invest tax efficiently on your behalf
- Appropriately locating your more and less tax-efficient holdings among your taxable and tax-favored accounts
- Ensuring that all of the members of your financial team are acting in tax-efficient concert with one another across the spectrum of your financial activities
All this and more is why the final piece in the puzzle is to engage a wealth manager like Hiley Hunt Wealth Management to organize the many moving parts and players involved, keep an eye on it all over time, and help you and your specialized team members make adjustments when appropriate. The savings achieved can more than offset your investment in ongoing oversight of your tax-wise wealth. That’s a good idea, any time of the year.
Learn more about Hiley Hunt Wealth Management and who we serve in Omaha, NE – Financial Planning and Investment Management
July 9, 2015
While “tax season” may imply that there is an optimal time to think about your income taxes, the best way to minimize your annual tax liability is to engage in year-round tax-wise investing, with ongoing best practices in:
- Your personal tax-efficient habits
- Your fund managers’ tax-efficient habits
- Your investment portfolio’s tax-efficient management
- Your advisers’ tax-efficient teamwork
You and Your Investments
There are a number of personal habits you can embrace that make for tax-efficient investing. Here are a few to get you started.
Have a plan … and follow it. Investing according to a plan, preferably in the form of a written Investment Policy Statement, makes everything else we’re about to describe easier to accomplish. By clearly defining and documenting what you plan to achieve with your investments and how you plan to achieve it, you and your financial team are best positioned to ignore the inevitable, often tax-incurring distractions along the way. A detailed investment plan also serves as your reliable guide for resolving any conflicting priorities when balancing tax efficiency versus other considerations within your overall wealth management.
Avoid hyperactive trading. Bottom line, the more trading you do in your taxable accounts, the more “opportunities” you create to be taxed on the proceeds. The fewer trades that are required to accomplish your investment plan, the better off you’re likely to be when taxes come due. (See how that plan is already coming in handy?)
Make good use of tax-sheltered accounts. It stands to reason, the more assets you can hold in tax-sheltered or tax-free accounts such as IRAs, Roth IRAs, 401(k)s, 529 college saving plans and health savings accounts (HSAs), the more opportunities you have to avoid or at least postpone the tax ramifications otherwise inherent in building capital wealth.
Inside Your Investments: Not Every Fund Is Created Equal
Next, consider your individual investments. Let’s say, for example, that your investment plan calls for holding a diversified mix of domestic and international stocks in your taxable accounts. Unless you’re planning to invest directly in thousands of individual securities (which we generally advise against), you will need to choose one or more funds to make up the desired mix. That’s where the challenge begins because, even if two funds share identical investment objectives, one may be considerably better than the other at tax-efficiently managing its holdings on your behalf.
It’s easy for fund managers and investors alike to ignore this important detail, because not all dollars lost to a fund’s tax inefficiencies show up in its published returns. Some of them may show up as annual capital gains distributed to fund shareholders (i.e., you), who must pay taxes on the gains at their individual tax rate – whether or not the share value of the fund itself has gone up, down or sideways.
In his article, “After a Bad Year for Funds Prepare for a Tax Hit,” Wall Street Journal columnist Jason Zweig reports this particular “gotcha.” When a fund that has dramatically plummeted in value is forced to sell highly appreciated holdings to meet shareholder redemptions, all shareholders must then share the burden of paying taxes on those realized gains, even if the fund value itself has declined. Ouch.
To minimize such scenarios and otherwise soften the blow of your fund’s taxable trading activities, it’s worth seeking out managers who exhibit best tax-management practices, especially for funds that you plan to hold in your taxable accounts. Following are some traits to seek.
Avoid actively trading funds in favor of evidence-based investing. Just as you should minimize your own hyperactive trading, your fund managers should do the same by heeding the academic evidence on how markets operate. Most managers try to “beat” the market by actively picking individual stocks or forecasting when to be in or out of it. Instead, look for mangers who are seeking to build lasting value by patiently participating in the long-term growth expected from the return factors being targeted. Evidence-based investing is not only a more sensible overall approach, it also is typically more tax-efficient.
Avoid hyperactive shareholders. As implied above, it’s best to invest in funds in which your fellow shareholders are less likely to panic-sell during bear markets. Undisciplined investors may force a fund manager to liquidate appreciated holdings to fund their flight, incurring distributed capital gains that you, as a fellow shareholder, must shoulder along with them. Investors who form personal investment plans, adopt an evidence-based strategy and choose like-minded fund managers to help them implement their plans should be better at retaining their resolve, even during volatile markets. T
Seek out tax-managed funds for your taxable accounts. Some fund families offer versions of their evidence-based funds that are deliberately tilted toward favoring tax-friendly trading over maximizing gross returns with no regard to the taxable consequences. Tax-friendly trading can include practices such as avoiding incurring short-term (more costly) capital gains, and more aggressively realizing available capital losses to offset gains. For additional insights, we recommend reading Larry Swedroe’s article, “Start Paying Attention To Tax Efficiency,” which describes a study that quantifies some of the costs and benefits of tax-efficient management.
Next Up: Tax-Efficient Portfolios, Tax-Efficient Teamwork
Beyond the best practices you can adopt within your personal investing and fund manager selection, there are a few more strategies for ensuring excellence in your year-round tax-wise wealth practices. We’ll cover these in the second half of our tax-wise investment series. In the meantime, let us know today if we can assist you with your own tax-wise investing.
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