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Your portfolios, estate plan in a climate of rising taxes

Gregory Crawford

So, have you been hearing anything about tax law changes recently? Of course you have, but how does this impact your portfolio and estate plan strategies? If there is anything positive to result from the fiscal-cliff political brinksmanship, it is that more families are looking at a tax-efficient investing and estate planning. Although Ben Franklin famously stated, “In this world nothing can be said to be certain, except death and taxes,” there are ways to minimize the tax impact. Unfortunately, we see many mistakes in both portfolio construction and estate planning that can easily be prevented.

Portfolio investing retirement accounts and taxable accounts

Do you own a mutual fund in a taxable investment account (non-retirement)? If the answer is yes, you are losing between 1.4 percent to 2.4 percent in annual returns as a result of taxes, depending on your tax bracket. This is one of the most common and easily addressed issues in a portfolio. The solution? Do not use actively managed mutual funds in your taxable portfolio, period. Why? Whenever a mutual fund sells a security in its fund, it creates a taxable event, either a long-term or short-term gain could be generated. That gain is taxable and that tax liability is passed onto the fund shareholders. Short-term gains are taxed at the individual;s ordinary income tax bracket. This can be significant for those with large mutual fund positions and in a high tax bracket. Using exchange-traded funds and index mutual funds from companies such as Vanguard, Charles Schwab or iShares will immediately add to your performance in a taxable account. In an environment of rising taxes, it is critically important to review your taxable portfolio for these issues.

Additionally, are you creating phantom income for tax purposes by holding inflation-protected or zero coupon bonds in a taxable account? This is a common mistake, and a certain no-no. You are paying taxes on income not received, because each year you receive a tax bill on the accrued interest, even though you don’t receive the actually cash until the bond matures. These types of investments belong in tax-deferred/retirement accounts rather than taxable accounts.

Retirement savings also have their own strategies to optimize returns. Are you maximizing your retirement account (tax-deferred) contributions (401(k), 403(b) IRA, etc.) each year? Many employees unfortunately stopped contributing when employers cut back or eliminated matching programs. This is a big mistake. I have yet to meet someone who says “I made a mistake by saving too much for retirement.” When you are designing your retirement portfolio, fund selection is also important. These are long-term investments in which portfolio performance depends upon allocation decisions and expenses. Does your employer offer investment options other than expensive mutual funds as choices? Changes in tax law make the advantages of tax-deferred accounts even stronger, particularly if you have low-cost (indexed and ETF), long-term investment options in your plan.

With all of these potential portfolio pitfalls, what is the best approach to designing a well-diversified portfolio of taxable and tax-deferred investments? Here are general pointers to follow for both taxable and retirement accounts:

1. Placement of your investments is critical. Place tax inefficient investments, such as high-yield bonds, real estate investment trusts, and actively managed stock funds (if used at all) in retirement accounts.

Place tax-efficient investments, such as index funds or tax-managed funds in taxable accounts. This way, you control the timing and impact of taxes by determining the sales and recognition of gains, not an anonymous fund manager. Large capitalization and value funds are typically more tax-efficient for holdings in taxable accounts than small-capitalization and mid-capitalization funds. Cash holdings , as well as municipal bond positions should also be held in taxable accounts.

2. If you absolutely must have an actively managed mutual fund in your portfolio, only hold these investments in retirement accounts. While the underlying investment expense ratios, turnover and internal trading costs are costly enough in any tax environment, at least in a tax-deferred account you can minimize some of these negatives.

3. Municipal bonds and tax-deferred annuities never belong in retirement accounts. While this may seem obvious, there is no reason for holding tax-advantaged investments inside a tax deferred account. Unfortunately, we see this at least once per month in portfolios that we review, particularly with tax-deferred annuities.

Estate planning

There are many reasons people don’t explore proper estate-planning strategies. Some people don’t like to think about their own mortality, or they don’t believe their situation is complicated enough to warrant a plan. Others think the process is too expensive. The reality is the opposite probate is more expensive than creating an estate plan and is also a lengthy and public process. As trustee, Alliance has been brought into estate situations where multi-million dollar checks have been written to the IRS. With proper estate planning the taxes would have been zero.

The American Taxpayer Relief Act of 2012 increases the marginal tax rate for estates and gifts from 35 percent to 40 percent, but it also makes permanent the $5 million exemption amount per person, and indexes this to inflation. The 2013 amount is expected to be approximately $5.25 million, per person. The “portability” of these exemptions, whereas a married couple has $10-plus million to use between them is now permanent law, as is the unification of the gift, estate and generation-skipping tax exemption amount. These steps taken by the government gives more clarity to estate planning than we have had over the past twenty years.

While a $5 million exemption may seem like a lot of room to work within your estate plan, remember that this is a total of all your assets, not just investable assets. Your estate includes your home, vacation property, cars, artwork, the value of your life insurance if you own your own policy and most importantly your business interest. Fortunately, there are discounting strategies that families can use for closely-held business which can expand the value transferred via these new exemption levels.

As we have seen over the years, taxation issues tend to be overlooked by many as it relates to portfolio investments and estate planning strategies. A proper approach can significantly improve your current portfolio returns, and the amount you can pass onto future generations or charity, not Uncle Sam.

Gregory Crawford, a Certified Financial Planner, is co-manager of Alliance Trust Company in Reno. Contact him at gcrawford@alliancetrustcompany.com or 775-297-4684.


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