There's a popular saying in personal finance: "It's not what you earn, it's what you keep." For many taxpayers, the end of 2016 was a reminder of this wisdom. Those with investments in taxable accounts are now receiving Forms 1099, and some taxpayers may be surprised when they're hit with a high tax bill.
As CPAs, we know that one drag on investment performance is taxes, and this year will undoubtedly result in several instances of clients asking: "How can I reduce my taxes?" Your clients may have taken advantage of the surprising 2016 bull market and sold some of their winning positions. Others may have owned mutual funds or exchange-traded funds (ETFs) that paid out higher than normal capital gain distributions and dividends in the fourth quarter of 2016. While year end has come and gone, the start of a new year allows clients to take a fresh look at their investment strategy and find opportunities to reduce their tax bill in 2017.
Proactive planning steps
You can discuss several planning strategies with clients. All of these have the same overall objective: minimizing taxes. With all of these strategies, it's important to keep in mind another popular saying in the investment community: "Don't let the tax tail wag the investment dog." In other words, minimizing taxes at the expense of after-tax financial gain is not a prudent course of action. All of these strategies should be considered net of taxes and transaction fees.
With that caveat in mind, here are some of the best planning strategies for your clients to consider:
- Asset location optimization: One of the most effective ways to reduce your client's tax bill is to implement a tax-efficient investment strategy. This strategy is particularly successful when clients have both taxable and tax-advantaged accounts (e.g., a traditional IRA and a Roth IRA). The first step is to identify the tax efficiency of each holding, which depends on a variety of factors such as fund turnover, dividend yield, and growth assumptions. Tax-efficient assets such as total market index funds should be placed in taxable accounts while tax-inefficient assets such as real estate investment trusts or high-turnover active funds should be placed in tax-advantaged accounts to shelter the capital gain and dividend distributions from current taxes. Over time, this strategy can help your clients generate higher after-tax investment returns.
- Tax-managed mutual funds, ETFs, and tax-favored assets: If your clients are committed to their particular investment strategy, it's advisable to explore more tax-efficient means of obtaining similar investment exposure. For example, some mutual funds have tax-managed versions of the same fund created with the mandate of limiting the shareholder's tax burden by lessening the number of sales and other taxable events. In other cases, when a client owns a mutual fund that attempts to mimic the performance of a stock or bond index (often referred to as index funds), consider whether there is an ETF alternative. ETFs have historically been more tax-efficient, due to their creation and redemption mechanism, which allows them to wash out capital gains without requiring distributions. Finally, if a client is in a high tax bracket and has significant taxable interest income, it may make sense to purchase tax-favored assets such as tax-exempt municipal bonds. Walking through a tax-equivalent yield calculation will help determine if there is an open window to benefit from this approach.
- Minimize (or even avoid) short-term gains: When reviewing a client's Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, do you see a large amount of short-term gains realized where the timing of the gain was within your client's control? Explain to the client that short-term gains are taxed at ordinary income tax rates, which can be as high as 39.6%, plus potentially an additional 3.8% net investment income tax on high-income taxpayers and state and local taxes. Were any assets sold a few weeks (or months) before the end of the calendar year? If so, now may be an opportunity to discuss how to avoid this practice in the new year.
- Rebalancing in tax-advantaged accounts: The main advantage of rebalancing a portfolio is to control for its risk and return characteristics. Because of the run-up in the stock market in 2016, many client portfolios were shifted back to target allocations to rebalance their investment mix, which may have resulted in gains or income being realized in taxable accounts. You can help your clients alleviate the tax impact of rebalancing by looking at the overall picture, not just specific accounts. Consider using assets held in tax-advantaged accounts (such as IRAs or 401(k) accounts) for the reallocation of funds to help minimize taxes generated by investment activity.
- Timing of mutual fund purchases and sales: Clients may need to purchase or sell funds near year end for a variety of reasons. You should educate clients on the mechanics behind mutual funds, which allow for distribution of capital gains (and losses) to their shareholders regardless of how long the fund has been held. When given a choice, it is often best to avoid purchasing new mutual funds shortly before they are expected to make large year-end capital gain distributions. Without this foresight, your clients could be taxed on gains a fund makes before they receive the benefit of the fund's investment returns, which is essentially the equivalent of "buying a tax liability." The opposite generally holds true for selling; if clients need to sell, they may want to do so before the distribution date. Helping clients estimate and anticipate mutual fund capital gain distributions should be an integral part of your year-end tax planning process.
- Tax-loss harvesting: Tax-loss harvesting should not be reserved solely for year-end planning. You can help clients review their investments quarterly and look for opportunities to harvest losses throughout the year. These losses can be used to offset year-end capital gains and up to $3,000 of ordinary income. Your clients will be happy to see you proactively working with them to reduce their tax bill on a consistent basis.
Call to action
For many clients, the CPA is their most trusted adviser. You have insight into their entire financial life, which provides for an abundance of opportunities to add value and remind them why you're an integral part of their team.
If you're unsure where to begin, start by reviewing your clients' tax returns with a renewed sense of curiosity. A checklist created by the AICPA Personal Financial Planning Division is a great resource to help initiate conversations about tax-savvy investing.
Sometimes, all it takes is asking the right questions. Once, while reviewing a client's prior-year tax return, I noticed an exceptionally high number of capital gain transactions spanning many pages. I explained to my client that he paid transaction fees each time the securities were bought and sold and that he was incurring short-term capital gains, which are subject to unfavorable tax rates. It quickly became clear that the investment adviser's strategy was not appropriate for my client. I helped him find a new adviser who could implement a strategy more aligned with his goals of tax efficiency and simplicity. Ever since, this client tells his friends that I saved his life! While it's an exaggerated statement, I'll take those endorsements anytime a client hands them out.
While it's generally understood that no one can control or predict the direction of markets, clients can control taxes, costs, and fees to some extent. This topic makes for a great springboard into other areas where you can add value as their CPA.
Use the start of a new year to be proactive and ask good questions. Your clients will be pleased with what they learn, and they may even save some money along the way.
Mark Astrinos, CPA/PFS, is a wealth adviser in San Francisco. To comment on this article, contact Chris Baysden, senior manager of newsletters at the AICPA.