State of the Markets
In the first few months of 2015 we witnessed a reversal of last year’s investment trends as U.S. corporate profits were dampened by the strong U.S. dollar and our domestic economy did not grow as fast as some predicted. Europe, on the other hand, looks to be on the cusp of a recovery and while the situation with Greece remains unresolved, any potential consequences look increasingly manageable.
The total returns for major asset classes are below.
U.S. equity markets experienced several pullbacks in January, followed by a steady upward trend in February, and a choppy March. After all this movement, the S&P 500 barely budged for the quarter (up less than one percent). However, small cap stocks (as measured by the Russell 2000) were up 4.3% in the quarter, a reversal of the large cap/small cap relationship seen last year. International equity markets advanced steadily during the quarter and handily outperformed the S&P 500. Bonds delivered a small return as yields continued to drift downward. These equity market trends - International outperforming domestic, small outperforming large - have continued into April and (as of this writing) gained momentum.
I write this letter on April 15th. Tax Day……the process is painful, the paperwork is excessive, the rules are complex, and the stakes are high. Whether you pay a lot or a little, I can’t imagine anyone not supporting a simpler approach to funding our government.
That said, we know that taxes can be a significant source of friction on your investment performance and managing investments for the best possible after-tax return is a priority. In keeping with the theme of tax time, we wanted to illustrate some of the tax management strategies we use to make sure you keep as much of your earnings as possible.
Tax Management 101
Below you will find basic descriptions of strategies we use across all of our portfolios. While not every investment firm goes to such lengths, these are standard operating procedures for Century Wealth Management.
Asset location – This is the process of locating specific assets (stocks, bonds, real estate, etc.) in specific accounts (brokerage, IRA, ROTH) with specific tax qualities (i.e. taxable, tax-deferred, and tax-free) to minimize tax liability and maximize the tax efficiency of the overall portfolio. This requires managing a portfolio of several accounts as one aggregated pool of money.
Tax lot accounting – Every purchase, every sale, every dividend reinvestment in taxable accounts is tracked by lot. This gives us the ability to track your cost basis, reconcile it with the custodian, and make subsequent sales in the most tax efficient way possible.
Tax loss harvesting – Tax lot accounting also allows us to identify situations when a security trades at a loss. In certain situations, selling the security and “harvesting” the loss can be beneficial, as these intentionally realized losses can offset other capital gains or be carried over for use in future years. Monitoring these opportunities and tactically taking advantage of them when the benefits outweigh trading costs is something we do on a continual basis.
Charitable donations with appreciated securities – Tax lot accounting also allows us to identify securities that will have the best bang-for-the-buck when donated to charity. Not only do donors receive a full deduction for the value of the security donated (either directly to a non-profit or through a donor advised fund), but they also benefit by avoiding the capital gains tax associated with selling the security. Donating appreciated securities, as opposed to donating the cash, is one of the most tax-efficient ways to give, and if properly coordinated with your overall investment plan, can result in large tax savings.
Advanced Tax Management
In addition to the strategies described above, there are several other advanced planning strategies that we help clients implement if the situation warrants.
Deferred annuities – Deferred variable annuities are insurance products that have underlying investment accounts. They usually come with high fees, lots of bells and whistles, glossy marketing materials, and commissioned salespeople. Generally, we are not fans. However, in some situations, using a low-cost annuity, we can create a tax deferred vehicle with the similar tax characteristics of an IRA. This can be an ideal vehicle to hold fixed income investments as part of our overall asset location strategy if we otherwise don’t have the capacity in traditional retirement accounts.
65 day trust distribution – Trusts can be very complex. Sometimes they pass their tax liability through to grantors or beneficiaries and sometimes a trust is taxed as an entity unto itself. If a trust pays taxes, it reaches the top tax rate quickly (at roughly $12,300 of income compared to $464,850 for married couples). In some cases, income that would otherwise be taxed on the trust level can be distributed to a beneficiary and taxed on their personal return at a lower rate. Incredibly, the IRS allows this to be done 65 days into the next calendar year. This counts as one of the very few tax decisions we get to make after December 31st, but it requires a very proactive approach and a thorough knowledge of all moving parts.
Integration with estate planning – In the same way that asset location can provide benefits based on account types, a multi-generational investment plan coordinated with long-term estate planning objectives can add significant value as well. By locating different asset classes and investment vehicles across family members and generations we can maximize the benefits based on the individual objectives of family members, their marginal tax rates, and various trust structures.
When it comes to investing someone smarter than I once said: “Focus on what you can control.” We believe managing tax liability clearly falls into this category and thus we put a lot of effort into maximizing the tax efficiency of your portfolio. Keep in mind that while this can add tremendous value over time, it is not reflected in the performance numbers you see in this report. It is, however, very much factored into the financial planning work and cash flow management done behind the scenes on your behalf.
If any of the strategies pique your interest or warrant further explanation, we are happy to meet and discuss them in detail.