Fallout from the pandemic in 2020 caused massive market dislocations and a bevy of asset purchases and sales. A good deal of that activity resulted in taxable events for sellers, and for many, an unwelcome tax bill.
Efficient tax strategy can make a big difference in your investment portfolio returns over the long term. The products you choose may affect your tax bills along the way, as will the timing of your asset sales. Smart decisions in these two areas can add up and make a meaningful difference in after-tax returns.
Tax Efficiency in Your Portfolio
Did you know that ETFs are generally more tax-efficient than mutual funds? This is due to an organizational feature that allows an exchange-traded fund to buy and sell holdings without passing through gains and losses to holders of the fund until the holder sells that ETF.
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An active mutual fund, on the other hand, does book gains and losses when assets are sold by the managers and passes them through to the customer at the end of the year. Not knowing ahead of time what those gains or losses look like can make tax planning difficult.
With ETFs you’re in more control of your tax destiny, whereas in a mutual fund, that control is in the hands of a portfolio manager. For that reason, some advisers recommend that mutual funds are more suitable for tax-advantaged accounts.
Using Time to Your Advantage
Anytime you decide to sell an asset, you should use some type of checklist to ensure you make an informed decision. Included in that checklist should be items such as asset type, valuation, momentum, alternatives for the money, and then there is the subject of holding period and tax.
When deciding whether to sell or hold, don’t forget about the time variable. If you sell an asset you’ve held for a year or less, it is treated as a short-term gain and taxed as ordinary income. Long-term gains are taxed at 15% for most Americans. But remember to take all variables into account when deciding what to do. If you feel an asset you’ve held for less than a year has neared a high or plateaued, sometimes it doesn’t make sense to wait for the asset to achieve long-term status. You could be risking a pullback in the asset that exceeds the difference between long- and short-term tax treatment.
For someone in the 22% tax bracket, waiting to sell is a bet that the asset won’t decline by 7%. Also consider the same thing in dollar terms. On a $1,000 gain, the difference in tax between the long and short gain is $70. Would you risk losing the entire $1,000 gain to save $70?
That question may be thought of differently for someone in a higher bracket, and different still for someone who has short-term losses to offset a gain. How about someone on the edge of being eligible for the Alternative Minimum Tax? They may be quite happy to hold the asset and take their chances rather than risk paying extra taxes.
Every sell/hold decision is unique unto itself and thus, there are few universal rules. In this dynamic environment, a checklist can help you make informed decisions regarding the if, what and when to sell. Go over that checklist and remember to consider all the factors involved, every time you make a sell/hold decision.
For a sample checklist of things to consider when you’re thinking about buying or selling, visit the Frazier Investment Management Blog at https://frazierim.com/fim-blog/frazier-investment-management-sellhold-checklist.
* Securities and advisory services offered through LPL Financial, a registered investment adviser. Member FINRA/SIPC.
* Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. LPL Financial does not provide tax advice. Clients should consult with their personal tax advisers regarding the tax consequences of investing.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Securities and advisory services offered through LPL Financial, a registered investment adviser. Member FINRA/SIPC.
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