There are times to stay the course and there are times when it's simply not an option. For advisors like Benjamin Tobias, CFP, last year was a reminder that amid periods of extreme volatility, adaptability is a virtue. Considering the recent financial upheaval, advisors need to be nimble and ready to adjust strategies on the fly, particularly when it comes to maximizing the tax-efficiency of client portfolios.
As 2008 came to a close, Tobias, principal at Tobias Financial Advisors in Plantation, Fla., implemented tax strategies that were far different from those he used when the year began. The emphasis then was on realizing capital gains to exploit the relatively low federal capital gains tax rate while it lasts, based on an assumption that lawmakers will likely increase the rate significantly in the not-too-distant future.
How quickly priorities can change. Now, Tobias says most of his tax discussions with clients center on harvesting losses. "We're talking about tax-loss harvesting with all our clients who have non-qualified assets. We started [executing tax-loss harvesting strategies] in August and September [2008], thinking that would be all. Then it got worse in October. Now, because of what's happened, you can almost liquidate an entire portfolio and start fresh."
A relatively straightforward maneuver usually reserved for specialized cases, tax-loss harvesting is occurring on a much broader scale this tax year because more investors have losses worth harvesting. Generally it means applying tax losses to offset tax gains. "It's worth looking at for anyone with a taxable account that is invested in individual stock holdings, mutual funds, ETFs, etc.," explains Susan O'Grady, CFP, president of Equipoise Wealth Management in Denver, Colo. "Basically you sell positions to realize capital losses and use those losses constructively to offset capital gains and ordinary income."
What makes the maneuver attractive is that losses can be carried forward into subsequent tax years (if net losses exceed the $3,000 maximum annual deduction) until they are exhausted, says Tobias. "I can see some clients [who harvest losses] not having to pay any capital gains tax for the next 10 years, even with markets rebounding nicely."
If the client wants to harvest losses from a particular position in a stock, mutual fund, or ETF, for example, but still likes the long-term outlook for that position enough to want to stay in it, they can liquidate the position, realize the loss, put the funds realized from the sale into a product with a similar profile for 30 days, then use the funds to purchase shares of the original vehicle after that, Tobias explains. Make sure the transaction complies with wash rules, O'Grady cautions, and be careful to always track basis. On the other hand, tax-loss harvesting also gives investors a good excuse to ditch a position they have been looking to exit anyway, she notes. In that case, wash rules would be moot because the client wouldn't be looking to re-assume the position he or she originally liquidated to harvest losses.
Tax-loss harvesting isn't a slam dunk in all situations, notes Jim Ivers, JD, LLM ChFC, professor of taxation at The American College. "Capital gain distributions from equity-based mutual funds in taxable accounts can be a problem, even in down market years, particularly if the fund has made a lot of redemptions," he says. "Many such distributions are made in December, but selling off the fund to avoid them generally won't help an investor that much. And it's the wrong reason to get out [of the position]."
Another maneuver that Tobias favors in the current environment is rolling funds out of a traditional IRA that lost significant value in the recent market downturn into a Roth IRA. First be sure the investor meets income eligibility requirements to qualify for lower tax rates on the rollover, and that the client is sufficiently liquid to pay taxes on the rollover amount, he notes. If so, the investor pays the relevant taxes up-front on the rollover amount, and now has funds in a Roth that can be used to purchase shares at very attractive prices, with lots of room for upside. "That's growth that you substantially never have to pay taxes on," he adds.
Growth potential and the prevailing low capital gains tax rate are two reasons why advisors such as Stephen Bonick, CFP, CPA, are suggesting certain clients look to tax-efficient investments in individual stocks. "There are some strong dividend-paying companies out there [with share prices] that are lagging as a result of market hysteria, so those companies are 'buys,'" says Bonick, principal at Tax and Financial Planning Associates in Beverly Hills, Calif.
The emphasis should be on companies with a strong track record, he says. "The last thing you want in this market is somebody to get whipsawed with tax and to lose economics [with a stock position]. So I'm looking to put my clients in strong-fundamental stocks that come with the tax-advantaged 15-percent dividend rates, stocks in companies that aren't going anywhere, and that have strong upside."
In this environment, O'Grady recommends keeping individual common stock holdings in taxable accounts. "We are making sure the individuals we advise are taking full advantage of the lowest [capital gains] tax rates they are likely to see for the rest of their lifetimes."
There are also compelling tax reasons to consider investments in individual bonds, according to Bonick and O'Grady. Both are steering clients to highly rated tax-exempt municipal bonds in particular because, as O'Grady notes, yields from tax-exempt bonds currently are significantly higher than those of their taxable bond equivalents. She favors individual bonds over bond funds because of the dual state and federal tax exemption offered by the former. From a tax perspective, says Bonick, it's also important to note that tax-exempt bonds "wouldn't have an [alternative minimum tax] preference because, with the new Democratic Congress and president, we are going to get jacked up to a 39.6 percent [AMT] rate pretty soon. That's a stimulus for me to look at tax-exempt munis, whether we have a bear market or not."
In a down market, exercise caution when considering corporate bonds and bond funds for taxable accounts, says Ivers. "Values on corporates are down, but the interest is still taxable. It's painful to take an economic loss on something for the year and still have a tax bite. Corporate bonds will likely come back, but right now I'd say they are better in tax-deferred accounts."
Rather than viewing the down market as reason to curtail contributions to a 401(k) or other type of defined contribution plan, O'Grady recommends that clients maximize 401(k) funding, or at minimum maintain current funding levels, provided they have the means to do so. "Suspending 401(k) contributions at this time, I think, can be foolish. I'm suggesting to clients that as long they stay within an acceptable level of risk tolerance, it would be wise to maximize those contributions, because in many cases they are buying shares at very low asset values. That puts them in a position to reap the benefit of upticks in share prices more readily over the long term."
The approach might be somewhat different with clients who plan to retire in the next several years, she says. In those cases, O'Grady's typical recommendation is not to curtail retirement plan contributions but to shift contributions into "safer, less volatile investments" -- money market funds, short-term bond funds, etc.
Despite all the repositioning triggered by the financial crisis, basic tax-management fundamentals have not changed, says Ivers. "From an efficiency standpoint, it's pretty much the conventional wisdom: indexed and tax-managed funds in taxable accounts, managed and/or actively traded investments in tax-deferred (retirement) accounts."
