As 2022 comes to a close, it’s important to look at your portfolio and see if you are aligned with your financial goals. There are ways you can potentially reduce the year’s tax burden. A little bit of strategic planning can go a long way to help you save on taxes and meet your investment targets.
1. Review and rebalance your portfolio
It’s that time of year when getting your finances in order and preparing for taxes means giving your investment portfolio a good hard look. You may need to rebalance if one of your holdings did exceedingly well, making it a disproportionate percentage of your entire portfolio. That means it’s time to sell some of the holdings and use the proceeds to buy other investments to put your overall allocation back in balance.
When buying and selling assets, there are a few things to keep in mind, such as your investment horizon. Perhaps you are approaching retirement age and need to transition to more income producing holdings. In this case, you may want to hedge your portfolio by buying an asset that does better in certain market conditions versus the rest of your portfolio.
2. Evaluate your capital gains
Another critical factor in deciding which assets to hold and which to sell is capital gains. Assets held for a year or less are subject to short-term capital gains and are taxed at the same rate as ordinary income. However, assets held for more than a year qualify for long-term capital gains and are taxed considerably below ordinary income. When choosing which assets to sell as you rebalance, consider the long-term capital gain tax advantages.
3. Assess gains and losses
Uncle Sam understands that the market moves both ways, with gainers and losers. If some of your holdings have gains, it may make sense to offset your capital gains tax burden by selling off others with losses. This strategy, known as “harvesting your losses,” comes with caveats and limitations, but it can be very effective.
4. Time your investments wisely
Timing can be everything when making a trade, especially when you factor in tax implications. Therefore, tracking when you buy and sell each investment is essential. Three notes to keep in mind about timing:
- If you sell a losing stock for tax purposes, you must wait at least 31 days before repurchasing; otherwise, the IRS will label it as a “wash sale” and disallow the loss. The wash-sale rule applies when purchasing stock options, shorting a stock, or purchasing through a spouse.
- There are a few options if you want to record unrealized losses to reduce your tax burden, but you still have long-term faith in the asset. One possibility is to sell your position at a loss, then purchase an exchange-traded fund (ETF) that invests in the same asset class. This maintains the sector exposure while exiting the company exposure. Or, you can double your current holdings temporarily and sell your original shares at a loss after 31 days, netting out the same but also capturing the tax loss. This is useful if you’re concerned about the security rising in price while you’re awaiting the opportunity to repurchase.
- If you plan to buy a mutual fund or an ETF, find out when it will distribute its dividends or capital gains. If you buy before the distribution, you will be required to pay taxes for the entire year, even if your shares haven’t appreciated. Conversely, selling before the distribution date may help you reduce your taxes.
5. Use accounts strategically
Consider whether your investments belong in a tax-advantaged account or a taxable account. For instance, there’s no additional tax advantage in holding tax-free investments (such as municipal bonds) in a tax-deferred account like a 401k or an IRA. Not only is there no additional advantage, but there’s also an implied penalty. When you finally withdraw your tax-free investment from the tax-deferred account, that tax-free income becomes taxed at ordinary income rates.
A tax-advantaged account allows you to defer taxes on those gains when you receive a lot of short-term capital gains (say, through a mutual fund that actively trades).
As you strategize where to hold your investments, remember that distributions from a tax-deferred retirement plan aren’t eligible for a lower tax rate on gains and dividends.
6. Choose which exact shares to sell
If you bought shares of the same investment at different times or prices, you can use picking and choosing to your advantage when it comes to selling—and for tax purposes. Rather than basing your sale on the average cost per share (which is the default for most mutual funds), you can specify which shares you want to be sold. In some instances, you may want to book capital losses to offset gains. In other cases, you may wish to minimize gains to limit taxes owed.
Similarly, you can decide which assets to sell based on when you bought them. The default for most stocks and bonds is “First In, First Out,” or FIFO. The shares purchased first are the first to be sold. You, however, can decide which shares to sell based on your goal: capital losses or gains.
The important caveat is that you must use the same method for the rest of the shares when it’s time to sell.
Talk to an expert to craft a strong investment strategy
It’s critical to include your tax advisor as well as your investment advisor as you plan. At First American Bank, we have experience handling a wide range of financial portfolios and creating investment plans for every need. Our investment advisors will walk you through every stage of your investment journey and tailor solutions to help meet your goals.
By partnering with us, you can make more informed, data-driven decisions. Looking to develop a comprehensive investment strategy to better position yourself to come out ahead at the end of the year? Contact First American Bank today.
*This information is for educational purposes only. It is not legal or tax advice. For legal or tax advice, you should consult your own counsel.
