Since Wednesday was PI day (3.14), I thought I might update my PI trade article, says Dave Landry, f...
Avoiding 5 Yearend Mistakes
12/25/2015 9:00 am EST
As each calendar year winds down, investors are often exhorted to get on the stick: to review their portfolios, rebalance, and scout around for tax-loss candidates, as December 31 is the deadline for most tweaks that can affect your tax bill for that year, explains fund expert Christine Benz, editor of Morningstar FundInvestor.
Yet, some of these tasks can be at odds with one another, specifically, what makes sense from a portfolio standpoint may not make sense from a tax standpoint and vice versa.
For example, the practice of rebalancing involves selling winners, while a tax savvy investor should be doing just the opposite: hunting around for slumping positions to sell in order to generate tax losses.
Indeed, a policy of benign neglect—that is, doing nothing to your portfolio at all—beats making portfolio adjustments that trigger unintended consequences. As 2015 winds down, here are some yearend portfolio mistakes.
1) Rushing into a Full-blown Portfolio Overhaul if You Don't Have Time
Yes, yearend is a good time for a portfolio review, in large part because December 31 is your deadline for most changes that can have an impact on your tax bill, like tax-loss selling.
But the fourth quarter is a busy time all around, with major holidays and work deadlines cutting into time for portfolio planning. If you find yourself time-crunched as the year winds down, don’t try to cram in a full-blown portfolio review.
Instead, think surgically about tasks that will deliver the biggest payoff—and lower your 2015 tax bill—if executed before yearend.
For example, make sure you’re contributing the maximum to your 401(k) or other company retirement plan, as the limits apply to each calendar year; making traditional rather than Roth contributions brings down taxable income.
If you’re on the hook for required minimum distributions and need to sell something to shake some money loose from your portfolio, start with those holdings that have appreciated the most over the past three or five years.
If you hold taxable accounts, it’s a good bet many of your holdings are selling above your cost basis. To find the most fruitful targets for tax-loss sales, concentrate on individual stocks, as well as emerging-markets, natural-resources, commodities, and precious-metals funds.
If you’ve realized losses elsewhere in your taxable portfolio—or some of your funds are making big distributions—you can use those losses to offset gains or up to $3,000 in ordinary income.
2) Automatically Kicking Laggards to the Curb
Yet, as beneficial as tax-loss selling can be, it’s a mistake to put on the chopping block everything that’s selling below your purchase price. Reversion to the mean happens and last year’s portfolio underachiever is often the next year’s saving grace.
For example, the soaring equity market that has prevailed for most of the past six-plus years has led to lackluster relative returns for otherwise-worthy high-quality funds, and some individual stocks, too.
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But such holdings could earn their keep in a weak market, providing valuable ballast for the more aggressive holdings that have soared in your portfolio.
While categories like Treasury Inflation-Protected Securities have disappointed in recent years, you might be glad you have them in case of an inflationary shock. That means that you’ll need to balance your quest for tax-loss sale candidates with portfolio and individual security considerations.
If you want to unlock tax-loss sales by selling something that’s depreciated, you can’t immediately replace it with the exact same security unless you’re willing to wait more than 30 days.
But you can maintain similar economic exposure by replacing your laggard with something like-minded…swapping an individual master limited partnership for another one with better prospects, for example, or selling an individual energy stock and buying an exchange-traded fund with a heavy position in that same company.
3) Rebalancing Without Considering the Tax Consequences
Yearend portfolio reviews often entail rebalancing, trimming highly appreciated securities while boosting positions in securities that have fallen in value.
Adhering to a consistent rebalancing regimen can reduce a portfolio’s risk level while also building in a contrarian streak. But even though rebalancing is sensible from the standpoint of portfolio optimization, it has the potential to jack up transaction and tax costs.
That’s one reason why it’s usually advisable to concentrate any rebalancing activity in tax-sheltered accounts like IRAs and 401(k)s, where trading costs are low and selling doesn’t trigger a tax hit. On the flip side, it’s worth employing a lighter touch in taxable accounts.
4) Buying Ahead of Distributions
If a portfolio review indicates that you’re light on certain asset classes, categories, or sectors, be careful about what you add to correct those imbalances during the fourth quarter.
That’s because mutual fund capital-gains-distribution season is upon us, and if you add a holding to your taxable account before it makes a payout, you’ll be subject to taxes on gains you weren’t around to enjoy.
If you want to make adjustments straightaway, a better bet is to focus on broad-market index funds and ETFs, which tend to do a good job of limiting taxable distributions.
5) Reflexively Dodging Capital Gains Distributions
If you expect a fund that you’ve owned for a while to make a sizable distribution and you hold it in a taxable account, selling preemptively can make sense if you wanted to lighten up on the position anyway, if it’s taking up too large a share in your portfolio, for example.
But if you like the holding and weren’t planning to sell, it’s rarely a good idea to preemptively sell a long-held position.
After all, you’re apt to have your own capital gains in the fund, so even if you were to sell in time to avoid the distribution, your selling would trigger capital gains taxes based on the difference between your purchase price and the current share price.
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