There is an old investing adage that goes: "No one ever got poor by taking profits." This alludes to the investor mindset that when something gets expensive, be a seller, not a buyer. However, this tax year, investors are about to receive some surprising news from their accountants. After a five-year bull market for stocks, capped by a 30+ percent gain in 2013, the tax man is knocking and the bills are higher than ever.
The American Taxpayer Relief Act raised tax brackets dramatically in 2013, and to pay for Obamacare, the new 3.8 percent net investment income tax is tacked onto almost every form of income. The impact on portfolios is dramatic. Consider the following example:
Say you have $10 million invested half in corporate bonds, yielding five percent, and half in stocks, yielding two percent with 25 percent turnover. The income from this portfolio is $350,000, and with the markets up 30 percent, $375,000 of realized capital gains (let's assume ¼ short-term and ¾ long-term). The federal taxes alone on this portfolio in 2012 would have been $177,500. In 2013, they would be about $240,000 -- a jump of about 35 percent.
So, how does an investor answer the tax man's knock, and more importantly, how does one invest going forward?
1. Maintain liquidity. In the short run, make sure there is cash available at tax time. Keep investments in redeemable forms, or at the very least have a standby line of credit to draw cash at any moment. Short-term interest rates are low, so this is an inexpensive safety valve.
2. Focus on asset location in addition to asset allocation. Keep higher-turnover and ordinary income-producing strategies in tax-deferred accounts such as IRAs and Defined Benefit Plans, and keep indexed, buy-and-hold, and tax-sensitive assets in personal names.
3. Reconsider buying municipal bonds. Money flowed out of the municipal bond market last year as the headlines focused on negative events in places like Puerto Rico and Detroit. The reality is that tax collection has risen across the country, credit metrics are improving, many states are running budget surpluses, and one can still buy attractive bonds backed by recession-resistant essential service revenues. Finally, when investors adjust for higher taxes, they keep much more income from an AA-rated municipal bond than an AA-rated corporate bond.
4. Plan ahead. The longer the run in bull markets, the more investors seek to take year-end losses to offset gains. Investors and their financial advisors should try to crystallize any capital losses in portfolios in October and early November, since extra cash will come in handy for investors during the winter holiday shopping rush.
My colleagues and I follow another adage: "It's not what you make, but what you keep that matters." With income and capital gains taxes on the rise, and interest rates as low as they are, it is more important than ever to achieve sufficient after-tax cash flow and keep the tax man at bay.