We’ve heard a lot about the updated tax laws — but it’s not too late to find tax inefficiencies in client portfolios. Think you’ve already checked? Think again.
Major changes made to marginal income tax brackets could have bounced your client toward a slightly different marginal taxable rate than in previous years. That means investment vehicles that used to be the most efficient could be draining returns from client holdings.
When fulfilling the fixed income allocation in an investor’s portfolio, marginal tax rates are used to evaluate the use of taxable and tax-exempt bonds. Since the absolute yields of the two types of bonds are not directly comparable, planners need to consider the taxable-equivalent yields when constructing the portfolio. The tax-equivalent yield is calculated by dividing the tax-exempt yield by one minus the investor’s marginal income tax rate.
For instance, a married client filing a joint tax return with $475,000 of taxable income was previously in the 39.6% federal income tax bracket. Now that same client falls to a 35% bracket for 2018. The new lower tax bracket may change the efficiency of using tax-exempt fixed-income investments.
For example, a high-grade 10-year municipal bond may have an average yield of approximately 2.5%, while a high-grade 10-year corporate bond may have an average yield of about 4%. The yield on the federally tax-exempt municipal bond likens to a 4.14% taxable yield for an investor in the 39.6% tax bracket, but the tax-equivalent yield falls to 3.85% for an investor in the 35% tax bracket. As a result, under a new, lower income tax bracket, the investor’s municipal bond portfolio may no longer be the most tax efficient investment choice.
Individual investors may also have their own unique set of tax characteristics. A review of a client’s prior year Form 1040 will reveal pertinent tax attributes, such as net operating loss and capital loss carryforwards. This presents an opportunity to orchestrate a strategy to either diversify low basis positions or harvest gains to increase the portfolio’s cost basis.
The preferential rates for long-term capital gains and qualified dividends of 0%, 15%, and 20% continue to apply under the new tax laws. If you become aware of a client experiencing a year with uncharacteristically low taxable income, it’s an excellent opportunity to query whether gains can be harvested, to a certain extent, free of capital gains taxes.
An important caveat to keep in mind is that tax considerations, while significant for taxable investors, may not always be the decisive factor in selecting optimal investment strategies.
Tax characteristics and changing brackets could offer opportunity to advisors who pay close attention to the details.