It is well known that taxes began to take a bigger bite out of income for the well-off in 2013. Top marginal tax rates rose, and some exemptions and deductions were phased out. What is less well known is that investors spending from their portfolios—even those investors whose tax rates didn’t rise—may be facing higher tax bills, too.
Historically low interest rates continue to depress the tax-exempt income from municipal bonds, so many investors spending from their portfolios have to sell assets to replace lost income. Given the stock market’s terrific gains over the past five years, selling stocks generally means realizing taxable capital gains, and most investors have few or no tax-loss carryforwards left from the dark days of 2008 and early 2009 to offset those gains.
Thus, smart tax management is more important than ever. Here are six key principles to keep in mind when considering tax-related strategies for 2014. It's not too soon to begin.
Don’t let the tax tail wag the investment dog. Maximizing after-tax investment returns within the investor’s risk and return objectives should be the goal, not minimizing taxes per se. After all, the best way to minimize taxes is to have no income. Investors who invest their entire portfolio in tax-exempt bonds may pay no tax on their investments, but they are unlikely to obtain the long-term growth they need.
Avoiding tax is permanent; deferring tax just kicks the tax can down the road—possibly to a time when tax rates may be higher. Tax-loss harvesting, while often beneficial, just defers tax to a future year. Sometimes, the transaction costs or bid-ask spreads may eat up most or all of the benefit.
Tax laws change, although not as often as it may seem. It may be prudent not to rely too much on any one tax-related investing or gifting strategy. Roth conversions, charitable remainder unitrusts, donor-advised funds and private foundations are among the often-valuable strategies with legislative risk.
Maintaining liquidity is important. Paying tax up front in a Roth IRA conversion or front-loading gifts to a 529 account may increase long-term after-tax wealth, but both strategies may leave an investor without easy access to needed funds.
Costs matter, too. Some tax-related strategies, such as a charitable remainder unitrust, require up-front or ongoing legal and accounting fees; they are generally most economical when applied to large amounts. Similarly, private foundations may maximize control over philanthropic gifts, but they are generally economical only for very large charitable programs. And today, high guarantee fees make some variable annuities unattractive.
Different taxes may require different strategies. Some strategies address federal income taxes; others address federal gift, estate and generation-skipping transfer taxes, or the many types of state and local taxes. Sometimes, a strategy that reduces one tax may increase another. It’s particularly important to watch the intersection of the income and estate tax regimes.
Every taxpayer’s goals and circumstances are different. The state you live in, the number of dependents you have, and your tax bracket, total wealth, embedded gains and losses, and time horizon will determine whether these strategies are likely to work for you.
Bernstein does not offer tax, legal or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decision.