Tax Optimization

Tax optimization is an important portfolio management strategy that Virtue Asset Management implements. Proper tax optimization can take advantage of tax loss harvesting, allowing the donation of appreciated stock to charity and most importantly there is the potential for large tax savings during the life of the client and at death. In this scenario we will look at the difference between a tax optimized portfolio and a simple portfolio that is not optimized.

Assumptions

  • $2,000,000 example
  • Tax Optimized example portfolio has $1,000,000 in stocks in the taxable account and $1,000,000 in bonds in the tax deferred account
  • Not Optimized example portfolio has $500,000 in stocks and $500,000 in bonds in both taxable and tax deferred account
  • Equities appreciate at 5% a year in this example
  • Fixed Income appreciates at 2% a year in this example
  • This is a 15-year scenario
  • No assets are withdrawn over this period
  • Proceeds for the taxable account will be taxed at capital gains rate: 23.8% is the highest current long-term federal tax rate
  • The Required Minimum Distribution (RMD) will be taxed at income tax rate: 43.4% is the highest current federal income tax rate

 

Results

  • In the Not Optimized example portfolio an investor will have equal amounts in both accounts.
    • The client will have $1,675,349 in the Tax Deferred Account
      • At age 70.5 the client will be required to start taking his RMD and in this example the RMD amount is $61,114.12
      • At the highest current federal income tax rate, the taxes are $26,536.55
    • The client will have $1,675,349 in the Taxable Account

 

  • In the Tax Optimized example portfolio, the taxable account ends up with the larger value because of the 100% weighting to equities
    • The client will have $1,345,868 in the Tax Deferred account
      • At age 70.5 the client will be required to start taking his RMD and in this example the RMD amount is $49,119.27
      • At the highest current federal income tax rate, the taxes are $21,317.76
    • The client will have $2,078,928 in the Taxable Account

 

 

Conclusions

 

In this example, if the client has an RMD in year fifteen the federal income tax savings between the optimized portfolio and the not optimized portfolio is $5,218.70 in year one. Even more savings will be achieved at death. After death, the tax deferred accounts will transfer to beneficiaries. The beneficiaries are required to take required minimum distributions based on their age and pay their federal income tax rate. The difference in ending market value between the tax deferred optimized and not optimized portfolio is $329,481 before taxes.

After death, the beneficiaries will receive a step up of cost basis in the taxable accounts. This means when they sell the investments, they will be taxed as if they bought them for what they were valued on the day the client died, not the price the client bought them for. In our example, the tax optimized taxable portfolio provides the beneficiaries $403,579 more in market value that would receive a step up in cost basis.

If the beneficiaries in this scenario needed the money from the taxable and tax deferred immediately the $329,481 difference in the tax deferred accounts would shrink to $186,486 after paying the maximum federal income tax rate of 43.4%. Fortunately, the tax optimized taxable account would pay no taxes. This leaves the tax optimized portfolio with an additional $260,585 for the beneficiaries the day after death.

 

Beginning Ending Taxes* Final
Tax Optimized
Taxable  $ 1,000,000  $   2,078,928  $                   –  $   2,078,928
Tax Deferred  $ 1,000,000  $   1,345,868  $      761,761  $      584,107
 $ 2,000,000  $   3,424,796  $      761,761  $ 2,663,035
Not Optimized
Taxable  $ 1,000,000  $   1,675,349  $                   –  $   1,675,349
Tax Deferred  $ 1,000,000  $   1,675,349  $      948,247  $      727,101
 $ 2,000,000  $   3,350,698  $      948,247  $ 2,402,450
*assuming the tax deferred account is completely liquidated and pays the 43.4% maximum federal tax rate

 

 

 

 

Tax Loss Harvesting

Tax loss harvesting is an active portfolio management tool that Virtue Asset Management utilizes to potentially lower current and future taxes. The tax code allows you to sell securities at a loss and you can use these losses to offset capital gains and reduce taxable ordinary income up to $3,000 a year. Another advantage of tax loss harvesting is that you can buy back the exact security you sold in 31 days.

The goal of tax loss harvesting is to sell securities at a loss to capture the losses for income tax purposes. If you sell a stock after holding it over a year, the highest capital gains rate you can pay is 23.8% if you are subject to the net investment income tax. The net investment income tax is a Medicare surtax of 3.8% on investment income. If you purchased a stock two years ago for $20,000 and sell it in a taxable account for $25,000 you will create a capital gain of $5,000. That $5,000 is then taxed at the capital gains rate and at the maximum rate of 23.8% the tax owed is $1,190. However, if you had another stock in your portfolio at a loss of $5,000 you could sell it in a taxable account and create $5,000 in capital losses. The $5,000 in losses offsets the $5,000 in gains and eliminates the tax of $1,190.

When you sell a security you have held for less than a year, you are taxed at your federal income tax rate. The highest federal income tax rate is 43.4% if you are subject to the net investment income tax. The short term rate is much higher than the previously discussed long term rate of 23.8%. This large difference in taxes creates a dilemma for investors when a recently purchased stock appreciates quickly. The question becomes: is it worth the risk to hold the stock for a year to only pay 23.8% in capital gains versus 43.4%. If the portfolio had created $5,000 in capital loss harvesting from a prior sale those losses could be used to offset $5,000 in short term gains and a cash savings of $2,170 ($5,000 multiplied by the maximum rate of 43.4%).

If you don’t have any capital gains for the year you can still take advantage of tax loss harvesting. The tax code allows you to take up to $3,000 a year in carryover losses to reduce your ordinary income. If you have more than $3,000 in losses, the losses rollover to future years or can be used to offset future capital gains from sales of stocks.

Tax loss harvesting is a valuable tool in a market pull back. Here at Virtue Asset Management we understand the concept and have the time and expertise to execute it correctly. For this scenario, consider a $1 million portfolio and the market drops 10%. In scenario 1 outlined below, the portfolio manager can sell the securities at a loss and purchase similar but not identical securities. After a 10% drop the portfolio manager realizes losses of $100,000. By purchasing similar but not identical securities the portfolio should appreciate at a similar rate if the securities weren’t sold. If the market then appreciates by 20% the portfolio is up to $1,080,000. The portfolio has $80,000 in gains which could be sold, if needed, and the $100,000 in losses would offset the gains. Therefore, the client would have zero capital gain taxes and $20,000 in carryover losses. In scenario 2 outlined below, the manager doesn’t make any sales. The portfolio has $80,000 in gains with no capital gain losses. If the client needed $80,000 they could pay as much as $19,040 in capital gain taxes (23.8%).

 

Scenario 1 (Tax Loss Harvesting) Scenario 2 (Static Portfolio)
Starting Value $1,000,000 $1,000,000
Value after 10% drop $900,000 $900,000
Tax Losses Harvested $100,000 $0
Value after 20% increase $1,080,000 $1,080,000
Taxes on $80,000 in sales $0 $19,040