A strong investment return can lose some of its impact when taxes are considered. If you have appreciated stock, several types of investment accounts, or proceeds from selling a business or real estate, the tax consequences of your investment decisions can become an important part of your financial plan.
Tax-aware investing looks beyond investment performance alone. It considers where assets are held, when gains and losses are realized, and how different strategies may affect what remains after taxes.
If one stock has grown into a large part of your portfolio, you’re getting closer to retirement, or you’re preparing to sell a business, taxes can start affecting decisions that once seemed straightforward.
What Is Tax-Aware Investing?
Tax-aware investing is an approach to portfolio management that considers after-tax results alongside investment risk and return.
Taxes are one of several factors investors may have some ability to manage. Decisions involving asset location, investment selection, realized gains, and realized losses can all influence how much of an investment return ultimately remains in your portfolio.
Larry Heller, CFP®, CDFA®, helps individuals and families connect their investment decisions with retirement and tax planning. Looking at these areas together can be particularly useful when a portfolio includes different account types, appreciated investments, or assets that may soon be sold.
Here are five areas worth considering.
1. Are Your Investments Held in the Right Types of Accounts?
A taxable brokerage account, traditional IRA, and Roth IRA don’t receive the same tax treatment. As a result, where an investment is held can be an important part of portfolio construction.
A Roth IRA generally provides tax-free growth, while a traditional IRA offers tax-deferred growth with withdrawals generally taxed as ordinary income. Taxable accounts can generate taxes from income, dividends, and realized investment gains.
This creates an opportunity to think about asset location, which involves deciding where different types of investments may fit across your accounts.
For example, the discussion identifies several general considerations:
- Investments with higher expected growth may be considered for Roth accounts
- Lower expected-growth investments, such as bonds, may fit differently within traditional IRAs
- Investments eligible for long-term capital gains treatment may have a place in taxable accounts
- Municipal bonds may be more appropriate in taxable accounts because their income can receive favorable tax treatment
These aren’t universal rules. Your investment strategy, tax situation, time horizon, and financial goals all influence how assets should be positioned.
Consider asking:
- What investments do I currently hold in each account?
- Am I considering the tax treatment of each account?
- Could the location of an investment affect my future tax liability?
- Have my account balances changed enough to warrant another review?
Asset location can be just as important as deciding which investments to own.
2. Could Tax-Loss Harvesting Help With a Concentrated Stock Position?
Holding a stock that has appreciated substantially can create a difficult decision.
You may want to diversify because one company now represents a significant portion of your portfolio. Selling that stock, however, could create a substantial capital gain.
Tax-loss harvesting may provide one way to address part of that issue.
The strategy generally involves selling investments in a taxable account that have declined in value. Those realized losses may then be available to offset realized gains elsewhere in the portfolio, subject to applicable tax rules.
This can be particularly relevant when gradually reducing a concentrated stock position.
Before selling appreciated stock, consider:
- How much of my portfolio is concentrated in this investment?
- What is my cost basis?
- How much gain would a sale create?
- Are there losses elsewhere in my taxable portfolio?
- How does diversification fit into my broader investment plan?
Taxes shouldn’t necessarily prevent diversification, but they can influence how that process is approached.
3. How Does Direct Indexing Create Tax-Loss Harvesting Opportunities?
Direct indexing provides another way to think about tax-loss harvesting.
Instead of owning an index through a single fund, a direct indexing strategy holds a selection of individual securities designed to broadly reflect the risk and return characteristics of an index.
Why does that distinction matter?
An index such as the S&P 500 can rise during a year while some individual companies within that index decline. When you own individual securities, those declining positions may provide opportunities to realize losses even when the broader market has performed positively.
Those losses may then potentially offset gains elsewhere in your portfolio.
Direct indexing isn’t appropriate for every investor, and taxes are only one consideration. Costs, portfolio construction, tracking differences, and your overall financial situation should also be considered when evaluating an approach.
4. Are There Other Ways to Address Highly Appreciated Stock?
Selling appreciated stock isn’t the only strategy that may be available when a position has become highly concentrated.
Depending on your circumstances, other approaches may include charitable giving or an exchange fund.
If charitable giving is already part of your financial plan, donating appreciated securities rather than cash may allow you to support an organization while addressing the embedded gain in those investments.
Exchange funds offer another potential approach. They may allow an investor to exchange a concentrated position for an interest in a more diversified collection of securities. These arrangements can come with specific requirements, including extended holding periods. The conversation notes that a seven-year holding period is common in these situations.
Before deciding how to address appreciated stock, consider how the strategy fits with:
- Your diversification goals
- Your charitable intentions
- Your need for liquidity
- Your investment time horizon
- Your tax situation
- Your broader estate and retirement plans
A concentrated position may have developed over many years, so addressing it doesn’t necessarily require an all-or-nothing decision.
5. Have You Planned for the Tax Impact of Selling a Business?
Selling a business can create one of the largest financial transitions an owner experiences.
For someone who started a company many years ago and has little cost basis, a sale may result in a significant realized gain. That makes the investment plan for the proceeds closely connected to tax planning.
One strategy discussed for these situations is long/short equity.
A long/short strategy can build on some characteristics of direct indexing while adding both long and short positions. This structure can create additional opportunities for tax-loss harvesting under different market conditions.
The strategy is more involved than traditional investing. Short positions and margin borrowing introduce additional considerations, which means understanding how the strategy works is important before determining whether it fits a particular situation.
If you’re preparing for a business sale or another major liquidity event, consider discussing:
- The expected gain from the transaction
- How the proceeds will be invested
- Your future cash-flow needs
- Existing gains and losses elsewhere in your portfolio
- Your tolerance for additional investment strategy considerations
- How the sale affects your broader retirement and tax plan
Planning before the transaction can provide more time to understand the available options.
When Should You Review Your Tax-Aware Investment Strategy?
Tax-aware investing isn’t limited to year-end tax planning. Changes in your portfolio or financial life may create reasons to revisit your approach.
A review may be worthwhile when:
- One stock has grown into a large percentage of your portfolio
- You’re preparing to sell a business or real estate
- You have substantial unrealized capital gains
- Your taxable, traditional IRA, or Roth IRA balances have changed significantly
- You’re making substantial charitable contributions
- You’re approaching required minimum distributions
- Your retirement income or tax situation has changed
The goal is to consider taxes alongside the other factors that influence your investment decisions.
Frequently Asked Questions About Tax-Aware Investing
What does tax-aware investing mean?
Tax-aware investing considers the tax consequences of portfolio decisions alongside investment risk and return. This may include asset location, tax-loss harvesting, capital gains, and the timing of investment transactions.
What is tax-loss harvesting?
Tax-loss harvesting generally involves selling an investment at a loss so the realized loss may be used to offset realized gains elsewhere, subject to applicable tax rules.
What is direct indexing?
Direct indexing involves owning individual securities designed to broadly represent an index rather than owning the index solely through a fund. Holding individual securities may create additional opportunities for tax-loss harvesting.
How can I diversify a concentrated stock position without selling everything at once?
Potential approaches discussed include tax-loss harvesting, charitable gifting, and exchange funds. The appropriate strategy depends on your portfolio, tax circumstances, liquidity needs, and financial goals.
Can tax strategies help after selling a business?
A significant business sale can create substantial realized gains. Long/short equity strategies are among the approaches that may be considered for creating additional tax-loss harvesting opportunities, although they also introduce additional considerations and won’t be appropriate in every situation.
Bring Your Investment and Tax Decisions Together
Investment decisions don’t happen independently from taxes. The accounts you use, the gains and losses within your portfolio, concentrated holdings, charitable plans, and major liquidity events can all affect your after-tax results.
That doesn’t mean every available tax strategy belongs in your portfolio. Each approach has advantages and disadvantages, and the appropriate choice depends on your individual circumstances. Reviewing these decisions as part of your broader financial plan can help you understand how the pieces interact.
If you have appreciated investments, multiple account types, or a major sale approaching, Larry and his team can help you consider how your investment strategy fits alongside your retirement and tax planning.
Retirement is more than a financial plan, it’s your life plan! Be sure to check out the latest episode of Retirement Unlocked for more insights into tax-aware investing and keeping more of what you earn. Listen to the full episode and explore more insights on tax-aware investing in the show notes on our website!
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- Phone: 631.248.3600
- Website: www.hellerwealthmanagement.com