Tax time is right around the corner so we have three tax-saving tips for your portfolio. First, evaluate any tax losses you carried forward from last year. Second, consider more tax efficient investments such as municipal bond funds that pay income that is exempt from federal and (possibly) state income taxes. Lastly, be sure you’re making the optimal choice when it comes to your retirement account contributions.
Use tax losses to book gains
Last March, we recommended investors maximize tax-loss harvesting opportunities. Now, with stocks having rebounded significantly from those March lows it provides an opportunity to use those losses against current gains. In one example, we sold IJH at a loss and immediately bought IVOO, which tracks the same market index (the mid-cap 400). Since that time, IVOO has rallied over 90%! Here’s a cool trick we can do at our discretion now:
- Take gains in IVOO up to the amount of losses taken in IJH last year (zeroing out any tax consequence)
- Immediately buy back into IJH, restarting our cost basis at a higher level, and not losing any of our desired index exposure
You might be wondering, what is the point of doing this instead of just continuing to hold IVOO? The answer is flexibility. We’re not creating any tax liability by taking profits in IVOO because our losses in IJH from last year cancel out those gains. However, when we rebuy into IJH we restart our cost basis at a higher level. Therefore, if mid-cap stocks go back down from here we have the option to again harvest tax losses (and swap back into IVOO, repeating the process). If mid-cap stocks keep going higher, we’ve reduced our tax liability because our cost basis is much higher now. Not to mention, tax laws could change, so why not execute these types of transactions now?
Rebalance & tax loss harvest in bonds
On a simpler level, if you haven’t rebalanced your portfolio in a while then be sure to factor in any tax losses from last year. Equities have outperformed bonds significantly in the last two quarters. Some investors may be putting off rebalancing for fear of triggering taxes on capital gains. In addition to using equity losses from last year against equity gains now, there are potential tax-loss harvesting opportunities currently available in two popular bond ETFs: TLT (swap into SPTL) and AGG (swap into BND, SPAB, or SCHZ).
Research muni bond funds
Municipal bonds generally pay income that is exempt from income taxes on at the federal level, and may be at the state level as well. These types of bond investments are readily available in an extremely liquid, and typically safe, ETF wrapper like MUB. However, MUB’s tax-equivalent yield has been pushed down to 1.43% which may not be attractive enough for some investors. In that case, if you’re willing to take on greater risks, there are some intriguing alternatives.
HYD is a “junk bond” version of MUB, with bonds issued by budget besieged states like IL, CA, NY, and NJ making up more than 40% of the ETF’s assets. This shows up in the ETF’s tax-equivalent yield though of more than 4%. Additionally, closed-end funds (CEFs) can offer even greater yield. The current interest rate environment may be favorable for CEFs as they typically use leverage to help boost returns. Right now, with the yield curve the steepest it’s been in years, leverage conditions are extremely favorable.
Our favorite muni-bond CEFs
Below are a few CEFs we own for some of our clients:
- MUI: Tax-equivalent yield of more than 7%. Income is exempt from federal income taxes.
- MYN: Tax-equivalent yield of more than 8%. Income is exempt from federal income taxes and New York State and New York City personal income taxes.
- MUJ: Tax-equivalent yield of more than 9%. Income is exempt from federal income tax and New Jersey personal income taxes.
- MUC: Tax-equivalent yield of more than 9%. Income is exempt from federal and California income taxes.
All of the above CEFs should be considered riskier than traditional fixed income securities. However, from a market performance perspective, a good proxy might be a junk bond ETF like HYG. In fact, last year MUI suffered a smaller drawdown than HYG during the Covid crash. Furthermore, on a yearly basis, MUI returned 8.90% in 2020 compared to 4.48% for HYG. The big look out on CEFs would be a rise in short-term interest rates, either induced by the fed or from market forces. That would likely have a negative impact on the aforementioned CEFs.
Pick the right retirement contribution
Our last tax tip for your portfolio has to do with the retirement contribution you make. We find many people don’t put much thought into their contributions, be it to a 401(k), Roth or Traditional IRA, etc. Retirement contributions are one of those things that’s just kind of on autopilot for many investors. But these contributions should be made with tax optimization as a priority. Here are a few things to keep in mind:
- Even if you don’t qualify for a Roth IRA, you can make a non-deductible IRA contribution and then do a backdoor-roth conversion.
- You can contribute to both a company 401(k) and a personal IRA (though contributions to that IRA may not be deductible depending on your income).
- If you’re self-employed then having a SEP IRA or solo 401(k) is a no-brainer. Read more about them here.
- Always contribute enough to your 401(k) to get your company’s match (it’s free money), but beyond that point make sure to weigh the pros and cons of maxing it out more thoroughly.
Study your options
If you can afford them and are eligible, you should almost always contribute to a retirement account(s). Even if you are not eligible to claim the tax deductions, you can still grow earnings on a tax-free or tax-deferred basis. If you’re a small business owner or have any type of 1099-misc income, you’re likely eligible to contribute to a SEP or solo 401(k). These types of accounts come with huge tax advantages, especially the solo 401(k).
For some people, contributions to their 401(k) will be the only ones that result in a tax deduction. In that case, it can make sense to max out the 401(k) even if plan options aren’t the best. If you’re eligible to contribute to your 401(k) and claim the deduction on an IRA contribution, then we’d generally recommend contributing enough to get your match, and then contributing the rest to your own IRA. IRAs usually provide better investment choices than traditional 401(k) plans. In addition, 401k’s are often housed at clunky service providers and it can be a pain to get your money rolled over after you leave your employer.
As tax season approaches, it’s time to start thinking about how your portfolio impacts your tax bill. Look back at your gains and losses from last year and see if you have any tax-losses you can use against current gains. Next, evaluate your fixed income sleeve for opportunities in municipal bond funds, which pay interest that can be exempt from federal and state taxes. Finally, think more carefully about the most efficient way to save for retirement instead of just doing what you did last year because that’s, “just what you do every year.”