Monday, December 1, 2014

Have a Taxable Investment Account? Time to Harvest



Tax harvesting is the process of selling assets for the purpose of creating either long-term capital gains or losses to minimize your tax bill. This procedure is usually conducted near the end of a calendar year. While many people are familiar with the concept of tax loss harvesting, fewer people are familiar with the more recently developed  process of tax gain harvesting. Between these two procedures, virtually everyone with a taxable (not tax-advantaged) investment account should make adjustments to their portfolio before the year ends.

Why Qualifies For the 0% Capital Gains Rate?

First, it is important to understand that capital gains (the growth on investments within a taxable, non retirement investment account) are taxed differently than ordinary income (wages, pensions, Social Security, IRA distributions, etc.). While short-term capital gains (recognized on the sale of assets held less than a year) are essentially considered ordinary income, long term capital gains, or recognized gains on assets held more than a year, are taxed at advantageous tax rates. While ordinary income tax rates range from 10% to 39.6%, capital gains tax rates range from 0% to 20%.

Second, it is crucial to understand what enables a taxpayer to qualify for the 0% capital gains rate. If a taxpayer is in the 10% or 15% ordinary income tax bracket, they qualify for the 0% long-term capital gains rate. For a married couple filing jointly, the 15% tax bracket ends at $73,800 of taxable income ($36,900 for single taxpayers). Thus, if a married taxpayer has a taxable income (which includes long-term capital gains but is also after deductions and exemptions) of less than $73,800, all their long-term capital gains will be tax free. If the taxpayer is in a tax bracket anywhere between 25% and 35% (taxable income of $73,800 and $457,600, or between $36,900 and $406,750 for single tax filers), they will pay long-term capital gains taxes at 15%. Only those in the top tax bracket of 39.6% (married taxpayers with a taxable income over $457,600 and single taxpayers with taxable income over $406,750) will pay capital gains taxes at 20%.

Tax Loss Harvesting

During the calendar year, assets have been purchased and sold in most taxable investments accounts. The sale of an asset creates a net gain or loss, both having tax implications. Investors should have an understanding of what their long-term capital gains tax rate will be so they can determine whether a taxable gain or loss is preferable.

For instance, an individual who does not qualify for the 0% capital gains tax rate may wish to minimize the amount of taxable gains they recognize during the course of the year, which would reduce their tax bill. If the investor currently has a net long-term capital gain (which is probable after the strong year the market had in 2013), then it is likely worthwhile to sell any assets in the portfolio that are currently worth less than the investor’s purchase price. This tax loss harvesting would reduce the net gain recognized during the year and lower the investor’s tax bill.

In some cases, by taking advantage of all potential losses within a portfolio an investor has the ability to negate all capital gains created during the year, completely eliminating their capital gains tax bill. Further, the IRS will allow investors to recognize a net capital loss of up to a -$3,000 per year. This -$3,000 loss can be used to lower the taxpayers ordinary income. This is particularly advantageous in that the capital loss reduces a type of income that is taxed at higher tax rates.

Harvesting Gains

Harvesting gains from a taxable portfolio is a more recently developed concept. Once the 0% long-term capital gains tax rate became a permanent part of the tax code with the passing of the American Taxpayer Relief Act of 2012 (signed January 2nd, 2013), in some scenarios it began making sense to recognize long-term capital gains on purpose to potentially avoid a larger tax bill in the future.

Suppose a taxpayer’s taxable income is consistently $65,000 a year. Additionally, suppose our hypothetical taxpayer won’t withdraw funds from his taxable account during the next few years, but may need a large lump sum distribution five years down the road. Recall that the 0% capital gains rate ends when a married taxpayer’s taxable income (which includes long-term capital gains) exceeds $73,800. Consequently, this hypothetical taxpayer has the ability to recognize $8,800 ($73,800 - $65,000) in long-term capital gains every year without increasing his tax bill. If this $8,800 in gains is recognized every year by simply selling and immediately repurchasing appreciated assets, he would raise the cost basis of his investment by $44,000 ($8,800 gain recognized annually for five straight years). He could then sell and withdraw that $44,000 without creating a tax liability.

Alternatively, if the investor does not harvest gains during the years when no distributions are taken, withdrawing $44,000 of gains five years down the road would create a sizable tax bill. He would still be able to recognize $8,800 of gains tax free in the year of distribution, but the remaining $35,200 of gains would cause his taxable income to be over the $73,800 limit, eliminating access to the 0% capital gains rate.  That $35,200 would be taxed at the 15% capital gains rate, creating a federal tax bill of $5,280. With proper planning, this significant tax bill can be avoided. 

The Bottom Line

Tax harvesting has no purpose in tax-advantaged retirement accounts such as IRAs and 401ks because all distributions from these accounts are taxed as ordinary income. However, taxable individual or trust investment accounts can almost certainly benefit from tax harvesting. Speak to your accountant and financial planner to understand whether capital gains or losses are desirable for you this year and determine the amount of taxable gains already recognized. This will help you determine what type of harvesting should take place.

Tax harvesting can be a difficult and confusing concept. However, a competent financial planner who utilizes this procedure within your taxable investment account can significantly lower your tax bill. Speak to your adviser to ensure you are reaping the tax benefits available to you.

Monday, November 24, 2014

My 2015 Market Forecast: All Forecasts Will be Wrong



The investment media is a rare industry in which professionals are rewarded for making bold projections but never punished for being wrong. The more outlandish a pundit’s forecast the more attention it receives. Yet, surprisingly little consideration is given to how accurate the prediction turns out to be.

At the beginning of 2014, there were some widely-accepted expectations regarding the investment environment. Let’s review those predictions and analyze how precise they really were.

Interest Rates

In a study conducted by Bloomberg at the beginning of the year, all 72 economists surveyed predicted higher interest rates and falling bonds prices in 2014. Consequently, investors were questioning whether they should reduce or eliminate the bond portion of their portfolios until the rate increase occurred.

So have we experienced this rise in interest rates? On January 1st, 2014, the yield on the 10-year Treasury note was 3 percent. On November 13th, the yield on the same note was 2.35 percent. That's right -- interest rates actually decreased significantly during the year. As a result, intermediate U.S. government bonds (ticker - IEF) produced a return of 7.38% during the year. Not bad for the conservative portion of your portfolio!

Quantitative Easing

The most widely promoted fear among forecasters was that the phasing out of the Federal Reserve’s quantitative easing (QE) program would diminish stock returns. Prognosticators worried that the Fed would lower the amount of loans the government would buy from commercial banks, thus reducing the amount of money available for new businesses to borrow leading to less innovation and the creation of fewer jobs.

So was the reduction of quantitative easing a legitimate fear? In fact, this possibility came to fruition. In December of 2013, the Federal Reserve was buying $85 billion of financial assets from commercial banks each month. The Fed reduced this amount during every meeting it held this year, finally eliminating the action completely in October.

However, the elimination of Quantitative Easing did not have a negative impact on the unemployment rate, which declined from 6.7% in January to 5.8% in October. Further, the S&P 500 has gained 12.31% year-to-date (as of 11/13/14). Clearly, fading out the Quantitative Easing program didn’t have the negative impact on stocks that many pundits expected.

Increased Volatility

Another widely held viewpoint at the beginning of the year was that 2014 was likely to be more volatile than anything experienced in 2012 or 2013. There was talk about valuations and P/E ratios being too high, concern about the war in Ukraine (ISIS wasn’t even in the headlines yet), and endless noise about unfavorable weather patterns impacting the market.

So has 2014 been a wild ride? Since 1929, the S&P 500 has experienced either a rise or a decline of more than 1% during 23% of trading days. In 2014, the S&P 500 moved more than 1% only 15% of the time. Less movement equates to less volatility, so again forecasters were inaccurate.

2015 Forecasts

Bloomberg News recently published a story titled Predictors of ’29 Crash See 65% Chance of 2015 Recession, in which the grandson of a prognosticator who luckily forecasted the Great Depression is still getting attention for a guess his grandfather made 85 years ago. If giving credence to forecasters isn’t ridiculous enough, suggesting there is a gene for forecasting is insane!

The article doesn’t mention that the same grandson made similar headlines with the same forecast in both 2010 and 2012; of course, those predictions did not work out so well. You will start hearing many 2015 projections soon, so pay no heed. 

Ignore the Pundits

The most significant lesson inherent in these numbers is that market expectations are essentially useless. Despite their abysmal track record, the news media loves forecasters because they capture attention and fill space. Unfortunately, pundits making projections are rarely held to their inaccurate forecasts and are allowed to continue making a living showing they have no greater knowledge than the average investor. 

Of course, this is not to say that interest rates will never rise, that bond values will never decline, and that the market won't return to the roller coaster it is. In fact, all those things are certain to happen. Unfortunately, anyone who contends to know “when” likely doesn't actually know anymore than you or me. For this reason, having and sticking to a diversified investment strategy that coincides with a detailed financial plan is the most probable path to financial success.

Friday, October 24, 2014

The Short-Term Implications of Diversification



Asset allocation is one of the key factors contributing to long-term investment success.  When designing a portfolio that represents their risk tolerance, investors should be aware that a portfolio that is 50% stocks is likely to obtain approximately half of the gain when the market advances but suffer only half the loss when the market declines. 

This general principle frequently holds true over extended investing cycles, but can waiver during shorter holding periods. For example, a fairly typical client of mine who has a 50% stock, 50% bond portfolio has obtained a return of 3.16% over the last 12 months, while the S&P 500 has obtained a return of 11.40% over the same time period (as of 10/20/14). An investor expecting to obtain half the return of the index would anticipate a return of 5.70%, and by this measuring stick, has underperformed the market by over 2.5% during the last year. What caused this differential?

The issue resides in how we define “the market.” In this example, we use the S&P 500 index as a measure for how the market as a whole is performing.  As you may know, the S&P 500 (and the Dow Jones Industrial Average, for that matter) consists solely of large company U.S. stocks.  Of course, a diversified portfolio owns a mixture of large, mid, and small cap U.S. stocks, as well as international and emerging market equities. Consequently, comparing the performance of a basket of only large cap stocks to the performance of a diversified portfolio made up of a variety of different asset classes isn’t an apples-to-apples comparison.

Frequently, the diversified portfolio will outperform the non-diversified large cap index because several of the components of the diversified portfolio will obtain higher returns than those achieved by large cap holdings. However, the past 12 months has been a case where a diversified portfolio underperformed the large cap index because large cap stocks were the best performing asset class over the time period.  In fact, over the last twelve months, there has been a direct correlation between company size and stock performance (as of 10/20/14):

Large Cap Stocks (S&P 500): 11.40%
Mid Cap Stocks (Russell Mid Cap): 7.08%
Small Cap Stocks (Russell 2000): -0.49%
International Stocks (Dow Jones Developed Markets): -3.21%
Emerging Market Stocks (iShares MSCI Emerging Markets): -4.09%

Since large cap stocks were the best performing element of a diversified portfolio over the last 12 months, in retrospect, an investor would have obtained a superior return by owning only large cap stocks during the period as opposed to owning a diversified mix of different equities. Does this mean owning only large cap stocks rather than a diversified portfolio is the best investment approach going forward? Of course not. Year after year, we don’t know which asset category will provide the best return and a diversified portfolio ensures we have exposure to each year’s big winner. Additionally, although large caps were this year’s winner, they could easily be next year’s big loser, and a diversified portfolio ensures we don’t have all our investment eggs in one basket.

Don’t be overly concerned if your diversified portfolio is underperforming a non-diversified benchmark over a short period of time. As always, long-term results should be more heavily weighted than short-term swings, and having a diversified portfolio is likely to maximize the probability of coming out ahead over an extended period.

Friday, October 17, 2014

Market Correction? Remember the Ace Up Your Sleeve



After the historic growth the stock market has experienced since early 2009, many investors have felt that a healthy pullback may not be a completely negative thing. After all, we certainly don’t want another bubble, or stock prices that are clearly out of line with the earning potential of the underlying companies.

Unfortunately, market corrections never feel healthy when they occur. People get uncomfortable when the market declines, the media fans the flames by giving investors reason after reason to be afraid, and worries that this is the beginning of the next crash begin to develop.

While many investors admit that a 5% pullback is manageably unpleasant, concerns expand when the market decline hits 10% -- right when the media can officially throw around the word “correction.” As of market close on 10/17, the S&P 500 is still only off less than 6% from its high on 9/18. Consequently, we still have a ways to go before we touch the “correction” mark. Of course, we have no idea whether the drop will reach 10%, but why not mentally prepare ourselves by exploring what has traditionally happened to stock prices once that 10% decline is crossed?

The Data

Ben Carlson, an institutional investment portfolio manager, looked at the S&P data going back to 1950, and found that there have been 28 instances when stocks fell by 10% or more. Thus, on average, the market has entered an official correction every 2.25 years. The last market correction occurred in 2011, so another 10% drop at this time would correlate pretty close to the average amount of time between corrections.  Of course, the market has done pretty well since that last temporary correction in 2011. Clearly, such a drop is quite normal and far from historically concerning.

 

As you can see, the average market correction lasts just under 8 months and the median total loss was 16.5%. Of the 28 times the S&P 500 decreased by 10%, the market suffered a loss greater than 20% only 9 times (32% of the time), and a loss greater than 30% only 5 times (18%). The data confirms that although these types of large losses do occur, they really are the exception -- even after enduring a 10% loss that feels like the beginning of the end.

Your Advantage

Are you thinking “I don’t think I can stomach that median loss of 16.5%?” Then it’s time to pull out the ace up your sleeve.  Remember that the data above represents the historical performance of the S&P 500 – an index that is composed of 100% stocks. A capable financial planner would ensure you have an asset allocation mix between stocks, bonds, and cash that represents your tolerance for risk. Consequently, your portfolio likely isn’t 100% stocks. In fact, the appropriate allocation for an average investor approaching or already enjoying retirement might be closer to only 50% stocks. This means that on average, your portfolio should decline only half as much as the S&P 500 during market downturns.

This ace may bring the loss endured by our sample investor with a 50% stock portfolio down to around 8.25% during the median decline.  Are you now back in the “manageably unpleasant” range? If so, you likely have an appropriately constructed portfolio. If not, your risk tolerance may need to be reevaluated to ensure you are not exposing your nest egg to a larger loss than you can endure.

Avoid Harmful Reactions to the Market

Although the recent market pullback produces what seems like a foreign feeling, we’ve been here before. The S&P 500 declined in value by 18.64% over a 5 month period in 2011. However, an investor with a 50% stock portfolio likely only saw their account values drop around 9%-10% -- still not fun, but manageable. Of course, we don’t know whether the market is about to bounce back or continue to drop into official correction territory. If you continue to hear about the broad markets declining, remember that the average historical correction has been far from catastrophic, and that you have the ace of an appropriate asset allocation up your sleeve.