Dec 27, 2018 3 min read

Three potential headwinds can affect investment performance: improper allocation (amount of stocks, bonds, cash, real estate and alternative investments in your portfolio); unreasonably high fees; and timing of transactions.

Left unchecked, each of the above can be a potential headwind against achieving desired performance. On the flip side, when properly handled, these items can turn into tailwinds. For example, higher fees paid to an investment adviser with superior results would be a good thing. Similarly, adept timing of your transactions through rebalancing can yield superior results as well.

In this article, we will focus on a fourth potential headwind: Taxes. Unlike the aforementioned items, I cannot think of one instance where paying taxes would help an investor. They have always been a headwind. So it is crucial to minimize their effect on our investment results.

Below is a checklist of items covering current year tax planning, as well as planning for farther down the road:

• At this time of year, we recommend that investors prepare an inventory of gains and losses from investment transactions, including unrealized gains and losses. Consider offsetting gains with unrealized losses if it makes economic sense.
• Consider allocating taxable bonds and high-yield bonds to an IRA or tax-deferred account. Bond interest is taxed at ordinary income rates.
• On the flip side, consider holding stocks and low turnover stock funds held within taxable accounts. This makes sense as their gains are taxed at long-term capital gains rates.
• Consider the type of investment vehicles you own. Traditional open end mutual funds are required to distribute at least 90 percent of net investment income and 98 percent of net capital gains each year. Index funds and ETFs, because of their low trading activity and minimal annual distributions,
• are attractive alternatives. When purchasing an active mutual fund, a good indicator of its tax efficiency is the turnover ratio. A lower ratio will generally yield a more tax efficient result.
• Consider holding municipal bonds within your taxable accounts. Municipal bonds pay interest that is exempt from federal taxation. Adding to the tax efficiency for Pennsylvania residents, interest from bonds from Pennsylvania issuers is also exempt from state taxation.
• Be sure to schedule and receive your IRA’s required minimum distribution. If you have more than one IRA, you may take your combined RMD from one source. The penalty for not taking the RMD can be 50 percent.

Be sure to allow for sufficient discussion before year end to meet with your adviser, review the tax efficiency of your portfolio, and implement preemptive tax reduction strategies.

Hapanowicz & Associates is an investment and wealth management firm based in downtown Pittsburgh. This is part of a series of occasional columns that Robert Hapanowicz and his daughter, Christina Hapanowicz, submit.

Robert is the author of this piece.