This post was written by Jim O'Shaughnessy, chairman, CEO and CIO at O'Shaughnessy Asset Management and by Scott Bartone, principal and portfolio manager at O'Shaughnessy Asset Management.
Thank heaven, tax season is over for now. Time to put taxes in the back of your mind until next year, right? Well actually, no, not if you want to reduce taxes paid on your investments next year. There are tactics that you can start using today to help minimize your tax bill in 2015.
Taxes can significantly erode investment returns if an individual investor or money manager is not accounting for them. Since short-term gains are taxed at a higher rate than long-term gains or qualified dividends, it is better to avoid triggering short-term gains if you can’t offset those gains with short-term losses. Look at the hypothetical portfolio assumptions in the table below. In this year, 50% of the positions were sold at some point, creating taxable impact. What the table below tells us is that while taxes can detract from returns, we can mitigate their impact by paying attention to whether we sell the positions at a gain or loss, and whether those gains or losses are short or long-term. We believe that smart and disciplined management does add value over just holding passive ETFs, but smart tax management is a key factor in any strategy.
What You Can Do to Minimize Your Tax Bill
Rather than simply waiting until the end of the year to sell losing positions, tax management is something that should be done throughout the year and should be incorporated into your investment strategy. By waiting until the end of the year to sell off your losers, you will likely drift away from your investment strategy. What’s more, you’ll likely not be the only one selling off losers at year’s end, and this negative momentum could push prices down further.
The better plan is to remain invested in your strategy and review your cost basis any time you are looking to trade. Reviewing your unrealized gains and losses throughout the year—rather than just the year’s end—will give you more “point in time” observations and more opportunities to harvest in your portfolio. If you have a well-diversified portfolio (as you should!), there are likely stocks that are at a loss throughout the year. Look at the S&P 500 over the past five years. If you only review it on an annual basis you only see positive returns, ma