Five Ways to Reduce Taxes on Your Investment Portfolio

The down markets of 2022 thus far have brought the attention of many aesthetic physicians to investing, often in an emotional way. As they see investment values decline, they are inclined to worry about their own financial situations. Under these circumstances, it is often wise to step back and develop a long-term and fresh perspective toward one’s portfolio. Part of this perspective should be to realize that, while many investors mistakenly focus on gross returns for a portfolio, it is the “net” after-tax returns that really count.

With this “net” focus in mind, ahead we offer you with five tactics to help reduce taxes on investments and bolster after-tax net returns.

Utilize Asset Location Wisely

Many are familiar with the term “asset allocation” as it relates to one’s portfolio. However, a common mistake made by many is failure to implement an asset location strategy. Individually owned brokerage accounts, Roth IRAs, and qualified plans are subject to various forms of taxation. It is important to utilize the tax advantages of these tools to ensure they work for you in the most productive manner possible.

For example, investment vehicles paying qualified dividends are preferred in an individual or joint brokerage account, while it is generally recommended for qualified accounts to own high yield bonds and corporate debt taxed at ordinary income rates. There are countless additional examples, but the lesson is that it is important to review the pieces of your plan with an advisor who will consider both asset allocation and asset location as they relate to your specific circumstances.

Consider Holding Periods

Long-term capital gains rates are much more favorable than short-term rates. Holding a security for a period of 12 months or longer presents an opportunity to save nearly 20% on the taxation of your appreciated position. For example, an initial investment of $50,000 which grows to $100,000, represents a $50,000 unrealized gain. If an investor in the highest tax bracket simply delays liquidation of the position (assuming the security price does not change), the tax savings in this scenario would be $9,800.

Although an awareness of the holding period of a security would appear to be a basic principle of investing, many mutual funds and managed accounts are not designed for tax sensitivity. High income investors need to be cognizant of this fact. Therefore, it is generally advantageous to seek the advice of a financial professional who is aware of holding periods and has experience executing an appropriate exit strategy.

Implement Proactive Loss Harvesting

One benefit of holding a diversified portfolio is that, if structured properly, the securities typically will not move in tandem. This divergence of returns among asset classes not only reduces portfolio volatility, but also creates a tax planning opportunity. When some holdings within a portfolio have experienced gains, while others have declined, an astute advisor can use this situation to save clients thousands of dollars in taxes by performing strategic tax swaps prior to year end. It is important to understand the rules relating to wash sales when executing such tactics. Because the laws are confusing and a mistake can result in additional tax liability, you should make certain your advisor is well-versed in tax-loss harvesting.

Use Appreciated Assets Charitably

A successful investor can occasionally find themselves in a precarious position. You may have allocated 5% of your portfolio to a growth stock with significant upside. Several years have passed, the security has experienced explosive growth, and it now represents 15% of your investable assets. Suddenly your portfolio has a concentrated position with significant gains, and the level of risk is no longer consistent with your long-term objectives. The sound practice of rebalancing your portfolio then becomes very costly, because liquidation of the stock could create a taxable event that may negatively impact your net return.

By planning ahead, you may be able to gift a portion of the appreciated security to a charitable organization able to accept this type of donation. The value of your gift can be replaced with the cash you originally intended to donate to the charitable organization; and, in this scenario, your cash will create a new cost basis. The charity has the ability to liquidate the stock without paying tax, and you have removed a future tax liability from your portfolio. Implementing this gifting strategy offers the potential to save thousands of dollars in taxes over the life of your portfolio.

Be Cognizant of Mutual Funds’ Tax Cost Ratios

The technical detail behind a mutual fund’s tax cost ratio is beyond the scope of this article. Our intent is to simply bring this topic to your attention. Tax cost ratio represents the percentage of an investor’s assets that are lost to taxes. Mutual funds avoid double taxation, provided they pay at least 90% of net investment income and realized capital gains to shareholders at the end of the calendar year. But all mutual funds are not created equal, and proper research will allow you to identify funds that are tax efficient.

A well-managed mutual fund will add diversification to a portfolio while creating the opportunity to outperform asset classes with inefficient markets. You do need to be aware of funds with excessive turnover. Moreover, an understanding of when a fund pays its capital gains distributions is critical. The bottom line: Understanding the tax cost ratios of the funds that make up portions of your investment plan will enable you to take advantage of the many benefits of owning mutual funds.

Conclusion: Tax Advice Matters

Implementation of one of these tactics alone, in any given year, may not make a huge dent in a physician’s tax bill. However, in combination and over time, they can significantly reduce taxes and increase net investment returns. Aesthetic physicians should choose advisors who will help them look beyond portfolio earnings and focus on strategic after-tax asset growth.

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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice, or as a recommendation of any particular security or strategy. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.