Taxes should not drive your investment choices. But if you can both invest wisely and potentially reduce taxes, all the better. That’s especially true now that it’s late in the economic cycle and there is potential for lower equity returns.
“In a higher equity return environment, after-tax returns of course matter, but there tends to be more tolerance for the tax drag a portfolio may experience. In a lower equity return environment, we do see increased client sensitivity to the tax drag a portfolio may experience,” says Bruce Robb, a J.P. Morgan Private Bank Equity Portfolio Specialist.
Recent U.S. tax reform has also created new opportunities for you to be tax-efficient as you invest.
Thomas McGraw, Head of Tax Advisory at the Private Bank, says: “We have ideas for assets, asset classes, and how to structure that exposure—you pick your spots.”
There are a number of tax-aware strategies for you to consider—either through select securities or through the way you structure securities:
Municipal bonds are tax-free at a federal level and may be tax-free at a state level, making them “very tax-efficient investments and a really important building block of a U.S. fixed income portfolio, particularly if you pay high local taxes,” says Irena Alagic, Global Fixed Income Strategist for J.P. Morgan Private Bank. The sector has had well-publicized challenges (Puerto Rico, Detroit), yet average credit quality remains consistent, and high-quality issuers have, in the past, held up well in crises. Municipal bonds tend to be negatively correlated to equities, underlining their role as ballast during late-cycle investing periods.
Private activity bonds are a type of bond issued by municipalities to fund projects for private businesses to use, such as airports, sports stadiums and housing developments. Interest from these bonds is generally free of federal taxes. But if are you subject to the alternative minimum tax (AMT), you will have to pay tax on the interest. So what’s the appeal? Fewer taxpayers now pay the AMT because of the new tax law. That means you may have more of an opportunity with private activity bonds to add diversification and yield to your municipal bond portfolio—without increasing your tax bill.
Some preferred stock (stock-bond hybrids) are tax-aware favorites for high-income taxpayers because their dividends are taxed at a lower rate than ordinary income.1 Major banks are large issuers, and we believe that, with banks’ improved creditworthiness, longer-dated bank-issued and select other preferreds could offer good, risk-adjusted carry in 2019.2 (We also like utilities and insurance.) Risks include volatility and vulnerability to interest rates and credit downturns.
Structured notes (SNs), which come in all shapes and sizes, can be fairly tax-efficient, says McGraw. In the United States, domestic SNs (properly structured) can be treated like capital assets by individuals.3 Held more than a year, they may receive the more favorable long-term capital gains treatment, McGraw says.
Qualified Opportunity Funds (QOFs) offer deferral of capital gain proceeds invested in QOFs, and potential forgiveness of taxes on capital gains for investments in Opportunity Zones (economically challenged areas) qualified by the U.S. government. The ideal investor would be comfortable holding for at least 10 years to secure the largest benefit available: full forgiveness on gains generated in the QOF.
A fund with real-time tax management—You may know about tax-loss harvesting, where you use realized losses to offset capital gains in a current or future year. Did you know tax-loss harvesting funds can do it for you automatically? By reducing investors’ tax liabilities, says Robb, these passive equity index funds can beat comparable funds’ after-tax performance (historically, 1.5%–2% greater).
An exchange fund—If you are sitting on large equity gains, you may have added risk because of concentration in a few well-performing stocks. Selling outright could create a tremendous tax liability. Enter exchange funds. These special-purpose private funds could diversify risk by exchanging your concentrated position for a broadly diversified, S&P 500–like equities basket without triggering a tax liability, Robb explains.4
Pass-through entities—Because of the new tax law, qualifying owners of certain pass-through entities may receive a 20% tax deduction for qualified business income distributions by these entities. It’s complicated, but worth exploring. Candidates whose income could qualify for favorable tax treatment include certain private equity portfolio companies, some real estate holdings, REITs and units of publicly traded partnerships (e.g., certain MLPs)—if organized as pass-throughs. “This 20% break is a big deal,” says McGraw.
Variable annuities—These contracts can be advantageous because the return within the annuity contract is tax-deferred and allows you to allocate and reallocate among your insurance dedicated funds (IDFs) without creating tax events.
Variable life insurance—These contracts provide the same tax-deferral features as variable annuities but with the added benefit of allowing you to make tax-free withdrawals during your lifetime. In addition, the life insurance death benefit would be free of income taxes for your heirs. Both private placement variable annuities (PPVAs) and private placement life insurance can be good ways to hold tax-inefficient investments such as some hedge fund strategies with high turnover.5
Speak with your accountant, tax attorney and J.P. Morgan team about how you may make your investments more tax efficient. Your advisor at J.P. Morgan is available to work with you and your other advisors on all your wealth planning needs.
Note: Tax-related information included in this piece is U.S.-focused and may not be applicable to global investors. J.P. Morgan and its affiliates and employees do not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any financial transactions.
1 The QDI—qualified dividend income—tax rate.
2 Our 2019 Outlook pointed to SiFis (systemically important financial institutions) preferreds. Assuming QDI qualification, a preferred with a 5.8% pre-tax yield would equate to 7.5% on an ordinary taxable-equivalent basis (effective federal-only tax of 40.8%).
3 On opinion of outside counsel if there is sufficient risk of capital and no principal guarantees.
4 Contributions of appreciated stock to a properly structured exchange fund are generally not taxable under current federal tax law.
5 Insurance dedicated funds are subject to various diversification rules and, while the policy holder can allocate the premiums among broadly defined strategies, it cannot be involved in any manner in selecting specific investments.
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