As year-end approaches, it is an excellent time to evaluate your taxable investment portfolio for potential tax-efficient adjustments. The decisions you make can significantly impact your overall returns, in the short and long-term. Key strategies such as tax-loss harvesting, custom indexing and focusing on total return (after accounting for taxes) can help you maximize the efficiency of your portfolio.
Here is a closer look at how these approaches can benefit your financial picture:
Tax-loss harvesting:
Even in a well-performing portfolio, some investments may not fare as well as others. Tax-loss harvesting, or tax-loss selling, allows you to sell underperforming investments to realize a loss that can then be used to offset gains in other areas of your portfolio. This strategy helps lower your tax liability by reducing the amount of capital gains taxes you owe for the year. Keep in mind, it is crucial to follow IRS rules, such as avoiding the “wash sale rule”, which disallows the deduction if you buy the same or a substantially identical security within 30 days of the sale.
The benefits of tax-loss harvesting include:
- Offsetting capital gains: Losses from the sale of investments can be used to offset gains in the current year, which can help minimize or eliminate the taxes owed on your portfolio gains.
- Carry forward losses: If your losses exceed your gains for the current year, you can carry them forward to offset future gains, providing ongoing tax relief.
- Reducing ordinary income: Up to $3,000 ($1,500 if married filing separately) of your realized losses can be used to offset ordinary income annually.
Custom indexing:
For investors seeking even greater tax efficiency, custom indexing is a powerful tool. Unlike traditional index funds that track broad market indices, custom indexing allows you to own individual stocks within an index and adjust those holdings based on your unique circumstances. This approach not only enables you to tailor the index to match your investment objectives but also allows for more precise tax management. Custom indexing is especially beneficial to investors with substantial portfolios or those who want to take full advantage of tax-loss harvesting opportunities throughout the year.
With custom indexing, you can:
- Capture tax losses: Own individual stocks and selectively sell positions that have declined in value to harvest losses, without disrupting the overall strategy of the portfolio.
- Optimize holdings for your tax situation: Avoid holding stocks with particularly high tax burdens or dividends that may not be tax-efficient in your specific situation.
- Adjust sector exposure: Modify your exposure to sectors or industries that may present tax opportunities without giving up the broad benefits of diversification.
Focusing on total return after taxes:
One of the most common mistakes investors make is focusing solely on pre-tax returns when evaluating portfolio performance. While strong pre-tax returns are important, it is essential to consider total returns after accounting for tax liabilities. Taxes can erode a significant portion of your investment gains, especially in taxable accounts. By focusing on after-tax returns, you align your investment decisions with maximizing your wealth, rather than simply maximizing the appearance of gains on paper.
When evaluating your portfolio, consider:
- The impact of capital gains: Long-term capital gains are taxed more favorably than short-term gains. Holding investments for more than one year can provide meaningful tax savings.
- Dividend taxes: High-yielding investments may generate substantial dividend income, but those dividends are subject to taxes. Tax-efficient placement of dividend-generating assets in tax-advantaged accounts can reduce the tax drag on your returns.
- Deferring tax liabilities: Where possible, deferring tax liabilities by strategically managing when and how you sell appreciated assets can increase the compounding power of your investments over time.
At McKay Wealth, we specialize in helping clients implement tax-efficient strategies tailored to their unique financial situations. If you are interested in reviewing your portfolio or learning about how these approaches could benefit you, don’t hesitate to reach out.
Disclaimer: This material is for informational purposes only and should not be considered financial, tax, or legal advice. Always consult with a qualified professional regarding your specific situation. All investment strategies involve risk, and there is no assurance that any strategy will achieve its intended results.