We all hope to accumulate a nice nest egg, but at some point the question arises: Can I do better? This lightbulb often goes off when we are planning for a money milestone such as retirement. The trouble is that in many cases repositioning investments can create taxable gains. And when we already feel overburdened by the income taxes we pay, it seems smart to minimize any taxes that might result from repositioning.
But how much emphasis should we put on tax consequences of our investments? Thinking long-term may often be a better strategy than focusing on taxes, as stocks go from tax-deferred to tax-free at death.
Let's look at a couple of examples.
Typically investors' overall goal is to sell off securities and reposition the proceeds into different, presumably more appropriate, investments. The first question to address is what to sell. The decision usually comes down to selling either securities which reflect the least capital gains, and thereby have been the dogs of the portfolio, or securities with high price appreciation that would result in higher taxes if sold.
This is a very common question I get from friends and clients alike: Do I sell stocks with high or low capital gains? CPAs have their obvious preference, but making investment decisions using tax considerations can lead to mistakes, because tax considerations are based on past performance.
My recommendation is based on an investment's future outlook — which holdings have the best or worst future prospects? I can honestly say that I have never made a good trade based solely on a tax analysis. The tax implications of a trade should only be a tie-breaker if there is no other clear reason to choose one holding over another for a specific transaction.
While selling a portfolio's laggards seems smart from both investment and tax perspectives, consider the investment strategy known as investing in the “Dogs of the Dow.” The strategy is to buy 10 of the 30 Dow stocks that have the highest dividend yield each year. In theory the high yield is a result of poor price performance.
Since the beginning of the century, the "dogs" have an average annual return of 8.3% and a current dividend yield of 3.85%. By comparison, the Dow Jones has an average annual return of just 6.7% and a yield of 2.81%. With this strategy, you sell the best-returning and highest-tax-liability stocks each year. But an investor partially offsets the tax bite by buying the new holdings at low prices.
The next issue is, what do you buy if you want to reposition proceeds? One recent email I received proposed selling individual securities to buy three different index funds. Index funds reputably have low annual taxes compared to individual stocks with taxable dividends and would add diversification to a portfolio. In this case the index funds in question were the Vanguard Global Minimum Volatility Fund (VMNVX), Vanguard S&P 500 Fund (VFINX) and Vanguard FTSE Pacific ETF (VPL).
From a tax standpoint, this seemed like a lot of work to go nowhere. In 2014 the funds above paid dividends equal to yields of 6.9%, 2% and 2.7%. Despite their low-tax reputation, index funds aren't necessarily more tax-efficient than a portfolio of individual stocks. Also, despite the diversification, this may not be a portfolio to hold throughout retirement because it has a very high proportion of holdings in foreign securities.
This portfolio could only be temporarily deferring gains until it is sold and repositioned into an income-generating portfolio at retirement. Wouldn't it make more sense to start accumulating dividend-paying investments now to last through retirement and avoid a capital gains tax hit right when you want to maximize your portfolio? What's more, if held through retirement, stocks become tax-free as they receive a stepped-up basis at death — they pass income-tax-free to your heirs.
The best way to minimize taxes on an investment portfolio is to buy quality stocks for the long term, and be patient.
Bill DeShurko is manager of the dividend and income plus portfolio on
Covestor, the online investing marketplace, and partner at
FundTraderPro.
