Balley Price Holdings: 4 things you need to do to protect your returns│BP Holdings Tax Management

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.

The Problem

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.

                                                                                                                                                                                                                                               Source: Yahoo Finance

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, making it difficult to realize offsetting losses.  However, if we look at returns on a monthly basis, we see that in 18 of 60 months, the S&P 500 had negative returns, and some of them were significant.  Even in years when the S&P 500 has strong returns, there are always inflection points when markets turn downward.  To offset gains for tax purposes, investors should take advantage of these periods to realize some losses in their portfolios.

Here's four techniques to use throughout the year:

1. Defer the realization of taxable gains until they go long term – Whenever possible, restrict the sale of a stock that is in a short-term gain position so as not to impose the higher short-term tax rate.  It is often worth delaying the sale of a winning position until you have owned it for more than a year, since the difference in tax rates is substantial.  The short-term tax rate is almost 20% higher (for top earners), so even if your investment has negative performance until it goes long term, you still may end up with more money on an after-tax basis then if you had sold it short term.

2. Target short-term losses within the portfolio to sell – Review your portfolio throughout the year and seek to strategically target sell short-term losses so you can use these as an offset.  Short-term losses can foil short-term gains that you may have earned across your other investments.  If you still have short-term losses after you have netted out your short-term gains, you can then use those losses against your long-term gains.  Finally, if there are still losses left, you can use them as a carry-forward to future tax years.  Again, doing this throughout the year rather than just at the end of the year will give you more chances to find losses in your portfolio.

3. Avoid wash sales when possible – In order to realize the tax benefit of realizing a loss, wash sale rules must be obeyed.  A wash sale occurs when a stock is sold at a loss, and within 30 days before or after sale, you also purchase the same stock.  Should a wash sale trigger, you will not be able to apply losses as an offset.

4. Gifting Securities – If you have a charity that is near and dear to you, gifting a security that has had significant gains can be a way to give to a good cause and also help your tax bill.  By gifting shares that you have held for longer than a year, you can avoid paying taxes on the gains and can also claim the full market value of the shares gifted as a charitable deduction at the end of the year.  Consult the charity of your choice to see if they have a mechanism in place to receive security gifts.

Take the time throughout the year to look at where your portfolio is positioned -  If you have generated significant gains throughout the year or think you will, look for opportunities to sell losses within your portfolio.  Taxes can be a significant drag on returns for individual investors.  You should apply the same rigor to both your investment strategy and your tax strategy to maximize your portfolio’s net performance.

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