Looking Forward to Looking Back
As we take time during the holidays to reflect on family and friendships, thoughts about our investments may be difficult to avoid.
Many holiday party conversations will certainly involve the recurring headlines regarding the sluggish growth outlook, issues in Europe or the historically high volatility in the markets we are confronting. Uncertainty makes for an especially challenging year-end financial and investment planning environment. In the spirit of the season, we will highlight a few ideas to provoke some optimism as this year comes to a close. Some of these thoughts will seem familiar but, much like your favorite holiday tune, are worth repeating.
Review Your Asset Allocation
After a year of turbulent market performance with dramatic daily runs in both directions, it is critically important to review your investment allocation. Empirical research supports that 90% of a portfolio’s variability and 40% of a portfolio’s returns over time can be explained by strategic asset allocation. Accordingly, any planning involving your investment portfolio must consider the effect on your allocation. Periodically rebalancing your portfolio toward your target asset allocation helps to make sure that your portfolio is properly diversified and weathers the full market cycle as designed. Given the reticence and pessimism many investors share regarding global market conditions, it might be a good time to consider a more defensively-positioned allocation while watching for opportunities that may arise amidst the many obstacles.
Review Your Investment Managers
To help supplement the returns generated from your asset allocation, it is also important to understand your investment manager(s). A good assessment of an investment manager’s place in the portfolio should include, at a minimum, a review of long-term performance in both up and down markets, overall cost and the strength of the investment team.
Review Your Asset Location
Many investors are contemplating how to best structure their investment assets to protect against the threat of rising tax rates. Most notably, the tax rate on qualified dividends could rise from the current level of 15% to 20% or even 39.6% for those in the highest marginal income tax bracket. Further, if you are subject to the Medicare tax on unearned income, an additional 3.8% tax may apply, bringing the total tax rate on your dividend income to 43.4%. With potential increases in tax rates, investors should diligently review how each of their assets are held. For example, a Roth IRA is an attractive place to hold a growth-focused investment that generates taxable income, since the income and appreciation on the assets are tax-exempt.
If you hold assets in a traditional IRA, a proactive response to the concern of rising tax rates might include locking in today's historically low tax rates by converting it to a Roth IRA. Further, since a Roth IRA does not require minimum distributions, the benefit of deferring distributions and compounded appreciation might outweigh any adverse change in tax rates (i.e., a subsequent decrease to marginal rates). Roth IRAs can also help mitigate the impact of additional Medicare excise tax.
Review Your Gains / Losses
You have surely heard that you should take advantage of tax-loss harvesting to minimize your current year taxes on capital gains. You may also recall that when implementing a tax-loss harvesting strategy, you need to be aware of the infamous “wash-sale” rules and the need to review mutual fund distributions to avoid surprise capital gains. This year, however, there may be additional considerations. For example, there may be some losses you want to lock-in to shelter subsequent year’s gains that may be taxed at a higher rate. Alternatively, if you feel strongly that capital gains tax rates will be increasing in future years, you may want to harvest some of the unrealized appreciation in your portfolio to preserve the current historically low rates on long-term capital gains.
Review Your Tax Basis
Another new concern for 2011 relates to the fact that your investment custodians are now required to report cost basis information to IRS for the sale of shares of stock purchased after January 1, 2011. Accordingly, it is even more important to review the records maintained by your investment custodians and be certain that your accounting method preferences regarding whether high-or-low cost shares should be sold first are well documented and reviewed periodically. These general account designations still permit you to designate specific shares to be sold, but you must confirm this information with the custodian before the settlement date, typically three days after execution. Additional types of securities (mutual funds, bonds, etc.) will eventually be subject to similar rules. Therefore, we would encourage you to review all of your records now to minimize headaches and surprising tax implications later.
Be Generous
A very important consideration for anyone with an IRA account subject to required minimum distributions is the ability to direct up to $100,000 of those distributions to charity. For investors with concentrated positions in low-basis stock, gifting portions of those positions is another great way to dodge recognizing significant capital gains while generating a current year deduction. If diversification is the ultimate goal, donating low-basis stock in appropriate tax years will lower your taxable income as well as diversify unsystematic risk associated with the concentrated holding.
We anticipate that investment and financial planning strategies will not dominate your thoughts during the holidays. However, a time of seasonal reflection may provide a prudent opportunity for a meaningful review of your strategic goals and objective investment planning.
