Although it is hard to believe, 2009 is nearly over. But before you get busy with the holiday season, you may need to make some important and necessary changes to your investment portfolio before the calendar year ends. This is particularly true if your investments are in a taxable account.
For mutual fund investors, December is normally the time that fund companies distribute capital gains to shareholders. While this may not be as big an issue this year as in years past because of the overall market decline, some funds will still make taxable distributions. Whether you invest in stocks, mutual funds, or both, you probably are facing unrealized losses in your portfolio. Nothing is more aggravating than watching your investments decline in value, and then be hit with gain distributions and have to pay taxes on them. This is the time to evaluate your portfolio and look for losses you can “harvest” to offset any capital gains that you may have or will receive. The question now becomes which investments are appropriate to sell and which to keep. You should consult your investment advisor and tax advisor to guide you through this process and insure that you do not create a “wash” sale.
Your overall investment plan should help guide you through your investment tax planning. This is the foundation all of your investment decisions should be based upon. Most people start out investing without a plan, and those that have a plan often drift away from it over time. Part of this plan is an overall allocation for your investment assets. Studies have revealed that the vast majority of a portfolio’s expected risk and return is determined by an investor’s asset allocation decisions—deciding what percentages of the portfolio should be placed in what asset classes. Now is an excellent time to fix problems with your portfolio and solve tax issues at the same time. A good strategy in lost harvesting is to sell assets that no longer fit your investment strategy and use the proceeds to develop a diversified investment mix that meets your goals and objectives.
When reallocating your investment dollars, another important factor is to make sure you won’t be paying unnecessary taxes in the future. You should look for funds that have a low level of turnover, and thus, greater tax efficiency. Index funds and other passively managed funds are inherently tax efficient, and make excellent building blocks for a diversified portfolio. Many fund families such as Dimensional Fund Advisors, Schwab, and Vanguard have also added tax-managed funds to their lineup. Tax managed funds can improve on the tax efficiency of index funds by the following strategies:
Another important factor is asset location—deciding which asset classes should be placed in taxable versus tax-deferred accounts. Even if you use tax-managed funds, there are some asset classes such as taxable bonds, real estate funds, and emerging market funds that are not tax efficient. These types of asset classes either have high dividend income or potentially high capital gain distributions. It makes sense to hold these assets in a tax-deferred account such as a 401(k) or IRA account, and to hold tax-managed funds in your taxable accounts.
By evaluating your portfolio now rather than after the start of the new year, you can help minimize your current taxes, while at the same time minimizing future taxes and updating your investment strategy.