Welcome to the sixth installment of Picking Up Pennies. Last month, we discussed reducing how often we trade by constructing holistic portfolios with fewer funds and not auto-reinvesting the dividends from those funds. We want to control trading and use the dividends to rebalance the portfolio as needed. Reducing trading reduces trading costs and taxes owed. Although trading often realizes taxes, there are methods of reducing taxes when you trade. This month, we will discuss how we minimize taxes when we trade and why we sometimes trade intentionally to reduce your tax burden.

•   Volume 1 – Keep Cash Balances Low (Better Chance for Higher Returns)
•   Volume 2 – Asset Location (Reduces Taxes)
•   Volume 3 – Using ETFs  (Reduces Taxes)
•   Volume 4 – Trading ETFs in Competition (Reduces Trading Costs)
•   Volume 5 – Number of Funds and Not Auto-Reinvesting Dividends (Reduces Trading Costs)
•   Volume 6 – Tax Lots and Tax Loss Harvesting (Reduces Taxes)
•   Volume 7 – Summary (Total Impact)

Tax Lots

Whenever you sell an investment, you hold the power to decide which “tax lot” to sell. A tax lot refers to a specific security purchase at a particular price and time. If you bought one share of Apple stock yearly for ten years, you would have ten different tax lots for Apple. One lot for each time you bought Apple. Each year, when you buy Apple, you buy the stock at a different price. This means that the gain and subsequent tax bill for each share of Apple will be different. When you sell one of those ten shares of Apple you own, you have the authority to decide which share of Apple to sell, as each one has a different tax consequence.

The default at most custodians/investment platforms is First-in-First-out (FIFO). When you sell one share, they assume you will want to sell the oldest share you bought. Often, this is not a tax-optimal strategy. Instead, the optimal approach is to choose the share with the lowest tax burden.

Figuring out which lot has the lowest tax burden is not always straightforward. You need to factor in things like wash sales and long vs short-term capital gain treatment. While we will not dive deep into capital gain tax law in this post,  rest assured, whenever we trade, we analyze the tax burden of every lot across every investment you have to minimize the tax impact to you. This allows you to keep more of your invested money and earn a higher after-tax return.

Tax Loss Harvesting

Another key advantage of focusing on individual tax lots is that it allows us to implement tax loss harvesting effectively. Tax loss harvesting involves strategically selling investments that have experienced losses. Since trading is costly, we are generally not searching for trades to place daily. We believe in taking the long view and holding diversified low-cost investments. However, every day, we look at every tax lot in your portfolio for opportunities to harvest losses. By selling individual tax lots at a loss, we can create and bank a tax asset for you: a tax loss. These losses can offset gains from other trades, allow us to rebalance the portfolio without a tax hit, or offset up to $3,000 of income each year. This strategy allows us to reduce your tax bill and realign your portfolio toward your long-term investment objectives.

Whenever we sell a position for tax loss harvesting, we immediately buy a different approved investment to ensure that you remain fully invested as your Investment Policy Statement would direct. We don’t want you to miss out on market returns to realize a tax loss. Most of the time, we will buy a security with a similar exposure to what we just sold to avoid “wash sale” rules, which, if violated, would negate the benefit of creating the loss in the first place. However, that is not always the case. We don’t want a blind tax loss harvesting strategy that does the same thing for everyone. We want to buy whatever asset class is the most underweight. Thus, each client and their situation will be treated uniquely based on their circumstances.

 We optimize our trading based on prior considerations and consultation with each client’s tax advisor so that we know and understand the parameters we should trade in. Further, by leveraging the insights gained from examining individual tax lots and implementing tax loss harvesting, investors can navigate the complexities of the tax landscape while maximizing their after-tax investment returns. We’re committed to treating each client uniquely and executing this strategy daily to pick up as many pennies as possible for our clients.

This information is educational and does not intend to make an offer for the sale of any specific securities, investments, or strategies.  Investments involve risk and, past performance is not indicative of future performance. Return will be reduced by advisory fees and any other expenses incurred in the management of a client’s account. Consult with a qualified financial adviser before implementing any investment strategy.

Welcome to the fifth installment of picking up pennies. Last month, we discussed how we trade ETFs by putting our trades in competition to improve the price we buy and sell ETFs for. Although we minimize trading costs, it still costs money to trade. Thus, we want to minimize how often we trade. We only want to trade when it is economically meaningful. This month, we will discuss how we minimize trading by selecting the ETFs we invest in and how we reinvest dividends.

•   Volume 1 – Keep Cash Balances Low (Better Chance for Higher Returns)
•   Volume 2 – Asset Location (Reduces Taxes)
•   Volume 3 – Using ETFs (Reduces Taxes)
•   Volume 4 – Trading ETFs in Competition (Reduces Trading Costs)
•   Volume 5 – Number of Funds and Not Auto-Reinvesting Dividends (Reduces Trading Costs)
•   Volume 6 – Tax Lots and Tax Loss Harvesting (Reduces Taxes)
•   Volume 7 – Summary (Total Impact)

ETFs We Use

The US investment universe has over 3,000 different investment companies. To help investors simplify and organize this vast universe, we generally split stocks into four categories: large, small, growth, and value.

Investment advisors will want to ensure they have some allocation to each of these four asset classes. They will try to find “the best” manager in each category. We could take a similar approach and find the best evidence-based fund in each category, but we take a more nuanced approach.

The world, and the publicly traded companies in it, is not a static place. Stocks often change which category they are in. For example, a small-value company may have significant success with a new product and quickly become a large-growth company. When this happens, a small-value fund, if it follows the fund’s Investment Policy Statement promised to investors, would need to sell that stock, and a large-growth fund would need to buy that stock. Thus, if we were like many investors, the two funds we own in aggregate would buy and sell the same stock and incur trading costs. Is that helpful? No!

This is why HIG uses market-wide solutions in our client portfolios. We use one fund that buys stocks in all four categories. This is beneficial for multiple reasons.

First, the ETF won’t buy and sell the same stock as it moves among various categories. On average, funds that only invest in one category have an annual turnover of around 25%, meaning that fully one-quarter of the holdings held on January 1 are sold by December 31 of that year. A market-wide fund has only about 5% turnover per year. Therefore, by investing in one fund instead of four, we cut the amount of trading down by 80% with the same net economic exposure. The same securities are held with less trading costs. 

Second, a market-wide fund reduces the need to rebalance the portfolio. Ultimately, we want to invest a certain amount of money in each category. The all-in-one ETF maintains those percentages without the need for additional turnover. However, if you use four funds individually, those amounts will shift over time. You may want 25% in each category, but due to performance differences, you may end up with 35% in one category and 15% in another. Over time, you must sell one fund and buy another to get them back in balance. This will result in trading costs and incur capital gains, increasing your tax bill.

On the face of it, using more funds sounds better than using fewer funds. However, less is more when you invest in the correct funds and understand the details. Less trading, fewer taxes, and more money in your pocket. 

Reinvesting Dividends

 Another way we save on trading is how we handle dividends. Every investment (ETFs, Mutual Funds, Stocks) produces dividends. Dividends are simply cash paid to an investor and represent a portion of the return you earn on any investment. Most advisors and investors elect to reinvest the dividends automatically. This means if you own ETF ABC, and it pays a $10 dividend, you will automatically turn around and buy $10 more of ABC. This is an easy way for investors to “set it and forget it.” However, this approach, although easy, is not optimal for investors. Why?

First, when you reinvest dividends, you need to go to the market and buy more shares of the ETF. The custodians that automatically reinvest dividends do not care about execution prices. They want to get the cash spent. They usually execute these trades early the following morning when spreads and trading costs are highest. As we talked about last month, trading ETFs can be costly when you don’t put them in competition. Thus, automatically reinvesting dividends usually results in higher trading costs. 

Second, we want to invest the extra cash in the asset class that you are underweight. Not the asset class that just paid you money. We want to examine your overall portfolio and determine if you need more stock, fixed income, or US or international exposure. By constantly investing the dividends in the most underweight asset class, we reduce the rebalancing needed in the portfolio over time. This reduces trading costs and taxes. Yes, it means that every quarter, when every ETF pays a dividend, we must go into every account and spend that cash. We do it because this approach improves investor outcomes with better trade execution and lower taxes over time.

This information is educational and does not intend to make an offer for the sale of any specific securities, investments, or strategies.  Investments involve risk and, past performance is not indicative of future performance. Return will be reduced by advisory fees and any other expenses incurred in the management of a client’s account. Consult with a qualified financial adviser before implementing any investment strategy.

Happy tax season! I realize that’s probably an oxymoron for most people, but I have a confession: I like it. Suppose you’re obsessed with numbers and details like me. In that case, digging through diligent records in your file cabinet at home, ticking and tying every dollar of income, dividends, and interest, and accounting for every possible deduction is not a bad day, in my opinion (and it just might be how I spent my Sunday afternoon this weekend. There’s no more football, what else am I supposed to do?). And when the amount due matches precisely what you had calculated six months earlier… boy, does that feel good.

I know I’ve lost most people by now, but to anyone who has read this far, I reward you with some last-minute reminders as you gather up your tax documents to send to your CPAs (or for the brave, as you fire up your preferred tax preparation software and do it yourself!).

1. You probably hear this every year, but there is still time to make a 2023 contribution to an IRA or Roth IRA! You have until the date that you file your 2023 taxes to contribute. We generally prefer the Roth IRA if you’re below the gross income limits for 2023 (single filers: $138,000 / joint filers: $218,000). If you’re above the income limits, you can still choose to make a Backdoor Roth contribution. This would involve making a nondeductible 2023 IRA contribution and then immediately converting that amount to Roth. These rules can vary from person to person, so please reach out to us if you’d like to discuss this!
2. Don’t forget about Roth IRAs for your kids! The only requirement to contribute to a Roth IRA is “earned” income. Babysitting, mowing lawns, washing cars…it all counts, even if no W-2 or 1099 is issued. There is no age limit as long as there is real earned income. I emphasize real because doing chores around the house or babysitting for siblings one night doesn’t count. As a general rule of thumb, the Roth IRA is fair game if you have your kids file a tax return for their income. Each child is limited to the higher of $6,500 or their earned income (so if they earned $1,000, the limit is $1,000). Another great benefit is that they don’t have to use their money. You can make the contribution on their behalf.
3.   If you have a high-deductible health plan with a Health Savings Account, ensure you and your employer contributions have hit the 2023 maximum ($3,850 for self-only coverage and $7,750 for family coverage). Add an extra $1,000 to that if you’re over 50. You have until your tax filing date to top off those contributions with after-tax funds.
4.  If you live in a state with no state income tax (where two of our three Hill offices reside – sorry, St. Louis), you will likely get a deduction for sales taxes you paid in 2023. You could collect every receipt and total the sales tax on every item you purchased in 2023 (and I would not judge you), or you can do what most people do and take the IRS’s estimated amount. Most people don’t realize, however, that you can also add sales tax from significant purchases on top of the estimated amount. If you bought a car, boat, or Super Bowl tickets (really anything that made you wince when you swiped the credit card), don’t forget to tell your tax preparer! Unfortunately, state and local taxes are limited to a total deduction of $10,000, so there’s a good chance your property taxes already exceed that limited amount anyway.
5.  If you have self-employment income (as reported on Schedule C), don’t forget to make a SEP-IRA contribution. The limit is based on your amount of self-employment income, but the contribution itself will also count as an “expense” against your self-employment income. Your tax preparer can tell you how much you can contribute to a SEP IRA.
6. Lastly, here’s a list of a few pesky little forms that can be missed. Don’t forget to send these to your tax preparer!

• Form 5498: If you have an IRA, you have a 5498! This is an informational form that tracks contributions and distributions from IRAs and Roth IRAs. You can file your taxes without it, but giving these to your CPA will ensure that your IRA cost basis information is kept accurate year over year, especially if you’ve ever made nondeductible (after-tax) IRA contributions.
• Form 1099-SA: If you took money out of a Health Savings Account in 2023, this form will report that amount. A copy of this is also sent to the IRS, so you might get a letter in the mail if you forget it.
• Qualified Charitable Distributions (QCD): If you sent any portion of a required minimum IRA distribution directly to a 501c(3)charity, your form 1099-R will NOT specify that. It’s the tax preparer’s responsibility to note any QCDs. If HIG facilitated a QCD for you in 2023, you have nothing to worry about. We’ll let your tax preparer know.

And if you’ve made it THIS far, I applaud you and thank you for sticking it out. I leave you with a quote:  “Of life’s two certainties, there is only one where you will be granted an extension.” –Anonymous.

This information is educational and does not intend to make an offer for the sale of any specific securities, investments, strategies, or tax advice.  Investments involve risk and, past performance is not indicative of future performance. Return will be reduced by advisory fees and any other expenses incurred in the management of a client’s account. Consult with a qualified financial adviser or CPA before implementing any investment or tax strategy.