The US tax reform just enacted has made effective tax management of portfolios far more valuable for some investors. The old rules of thumb never really worked, but their shortcomings will now cost investors more.
The American Tax Relief Act (ATRA) raised the top marginal income tax rate to 43.4%—the highest level since 1986. It also pushed the top capital gains rate from 15% to 23.8%. In a taxable portfolio, every trade has a possible tax impact, and the higher these rates, the greater the impact will be.
Once a trade has cleared the basic tax hurdle we discussed in a recent blog posting, the investor (or portfolio manager) must decide which lot to sell first. Most portfolio holdings consist of several tax lots purchased at different times and prices. In choosing which lot to sell first, a tax-aware portfolio manager aims to minimize an investor’s current tax payments by picking the one that will generate the lowest tax expense.
Most managers resort to a few accounting rules of thumb: HIFO (highest in, first out); LIFO (last in, first out); or FIFO (first in, first out). These techniques are relatively easy to implement but crude. HIFO will sometimes generate the lowest capital gains tax, but not always. If the highest-cost tax lot was bought less than a year ago, it will generate a short-term gain subject to a much higher ordinary income tax rate; in fact, it might incur the largest capital gains tax. LIFO and FIFO have similar limitations.
The only surefire way to sell the lots that will generate the lowest taxes is to calculate the tax cost of selling each and every tax lot and then pick the most favorable. Trading on the basis of calculations rather than rules of thumb may provide substantial benefits to all investors with taxable portfolios, but it is likely to be especially helpful to those subject to the new, higher rates. Maximizing after-tax returns is a complex endeavor that in most cases will best be left to professional managers who do a good job of incorporating taxes into their decision making.
Bernstein does not give tax or legal advice. Taxpayers should consult professionals in those areas before making any decisions.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Daniel B. Eagan is Head of the Wealth Management Group at Bernstein Global Wealth Management, a unit of AllianceBernstein. Paul Robertson is Senior Portfolio Manager at Bernstein Global Wealth Management.