The Year-End Investment Planning Process
Estimated Read Time: 8 minutes
The last thing any of us want to have to worry about this holiday season is another time-consuming task. However, year-end investment planning is one thing you can do now that will help set you up for financial success later on down the road. Not to mention, it will give you a head-start controlling any taxes you might end up owing next April. By setting aside a small amount of time this holiday season to make some strategic saving and investing decisions, you can make sure that your money will continue to work for you rather than against you. In this blog, we will be walking you through the steps for your year-end investment planning process.
The key takeaways for this blog are:
● Look at the forest, not just the trees (Invest for the future)
● Know when to hold ‘em (Holding periods)
● Make lemonade from lemons (Harvest your losses)
● Know where to hold ‘em (Tax-advantaged accounts and taxable accounts)
Look at the forest, not just the trees (Invest for the future)
The first step in your year-end investment planning process should be a review of your overall portfolio. This can shine a light on any rebalancing that needs to be done and whether the timing of any rebalancing should take place before or after December 31st for tax purposes. If one of your investments has performed particularly well, it might represent a greater percentage of your portfolio than originally intended. To bring your overall allocation back to an appropriate balance, you would need to sell some of your holdings and use the proceeds to buy other holdings. This is what is meant by rebalancing.
You should also make sure that your asset allocation is still appropriate for your time horizon and goals. Just keep in mind that diversification doesn’t guarantee a profit or insure against possible loss but is definitely worth considering as the first line of defense. You have options when it comes to investment management. For example:
- Being more aggressive if you’re not meeting your financial targets.
- Being more conservative if you’re getting closer to retirement.
- Consider adding an asset class that tends to react to market conditions differently than your existing investments do to increase diversification.
- Consider looking into an investment that you have avoided in the past if it now has a higher valuation.
Make sure you discuss your overall allocation and any rebalancing or reallocation strategies with your advisor to ensure they are in line with your overall financial plan.
Know when to hold ‘em (Holding periods)
When contemplating a change in your portfolio, don’t forget to consider how long you’ve owned each investment. Assets held for a year or less generate short-term capital gains, which are taxed as ordinary income. Depending on your tax bracket, your ordinary income tax rate could be much higher than the long-term capital gains rate, which applies to the sale of assets held for more than a year.
For example, as of 2022, the top marginal tax rate is 37%, which applies to any annual taxable income over $539,900 ($647,850 for married individuals filing jointly). By contrast, long-term capital gains are generally taxed at special capital gains tax rates of 0%, 15%, and 20% depending on your taxable income.
Your holding period can also affect the treatment of qualified stock dividends, which are taxed at the more favorable long-term capital gains rates. You must have held the stock for at least 61 days out of a 121-day period starting 60 days before the stock’s ex-dividend date. Preferred stock must be held for at least 91 days out of a 181-day period. The lower rate also depends on when and whether your shares were hedged or optioned.
As you can see, the rules get picky, so it is always a good idea to consult with your tax advisor when projecting taxes.
Make lemonade out of lemons (Harvest your losses)
Now is the time to consider the tax consequences of any capital gains or losses you’ve experienced this year. Although tax considerations shouldn’t be the primary driver of your investing decisions, there are steps you can take before the end of the year to minimize the potential tax impact.
If you have realized capital gains from selling securities at a profit, first off, congratulations! If you also have no tax losses carried forward from previous years, you can sell any losing positions to avoid being taxed on either some or all of those gains.
Don’t worry if you weren’t so lucky. Any losses in excess of your gains can be used to offset up to $3,000 of ordinary income ($1,500 for a married person filing separately.) Any unused losses can be carried over to reduce your taxes in future years.
Selling losing positions for the tax benefit they will provide next April is a common financial practice known as “harvesting losses.” If you’re selling to harvest losses in a stock or mutual fund and intend to repurchase the same security, make sure you wait at least 31 days before buying it again. Otherwise, the trade is considered a “wash sale,” and the tax loss will be disallowed. The wash sale rule also applies if you buy an option on the stock, sell it short, or buy it through your spouse within 30 days before or after the sale.
If you have unrealized losses that you want to realize, but still want to hold a specific stock or mutual fund, there are a couple of strategies you might consider. If you want to sell but don’t want to be out of the market for even a short period, you could sell your position at a loss, then buy a similar exchange-traded fund (ETF) that invests in the same asset class or industry. Or you could double your holdings, then sell your original shares at a loss after 31 days. You’d end up with the same position but would have captured the tax loss.
If you’re buying a mutual fund or an ETF in a taxable account, always find out when it will distribute any dividends or capital gains. Consider delaying your purchase until after that date, which is often near the end of the year. If you buy just before the distribution, you’ll owe taxes this year on that money, even if your own shares haven’t appreciated. And if you plan to sell a fund anyway, you may help reduce taxes by selling before the distribution date.
Know where to hold ‘em (Tax-advantaged accounts and taxable accounts)
Think about which investments make sense to hold in a tax-advantaged account and which might be better for taxable accounts. For example, it’s generally not a good idea to hold tax-free investments, such as municipal bonds, in a tax-deferred account (e.g., a 401(k), IRA, or SEP). Doing so provides no additional tax advantage to compensate you for tax-free investments’ typically lower returns. Not to mention, that tax-free income will become taxable at ordinary income tax rates when you withdraw it from the retirement account. Similarly, if you have mutual funds that trade actively and generate a lot of short-term capital gains, it may make sense to hold them in a tax-advantaged account to defer taxes on those gains, which can occur even if the fund itself has a loss. Finally, when deciding where to hold specific investments, keep in mind that distributions from a tax-deferred retirement plan don’t qualify for the lower tax rate on capital gains and dividends.
If you own a stock, fund, or ETF and decide to unload some shares, you may be able to maximize your tax advantage. For a mutual fund, the most common way to calculate cost basis is to use the average cost per share. However, you can also request that specific shares be sold. Which shares you choose depends on whether you want to book capital losses to offset gains or keep gains to a minimum to reduce the tax bite. (This only applies to shares held in a taxable account.) Be aware that you must continue to use the same method when you sell the rest of those shares.
Depending on when you bought a specific security, your broker may calculate your cost basis for you, and will typically designate a default method to be used. For stocks, the default method is likely to be FIFO (“first in, first out”); the first shares purchased are considered the first shares sold. Most mutual fund companies use the average cost per share as the default cost basis. With bonds, the default method amortizes any bond premium over the time you own the bond. You must notify your broker if you want to use a method other than the default.
Bottom line
There is a lot to think about during your year-end investment planning process. You might need to seek out help or advice from a financial planner or broker to be confident about making any changes to your portfolio. Keep in mind, there is always risk involved when dealing with investments, but there are ways to mitigate that risk and to try to make the best of a bad situation if you do find yourself caught up in one. Our suggestion is to do your homework and to get planning.
