Sheryl Rowling

Tax-Efficient Investing

You don't need to be a portfolio manager to provide tax-saving investment strategies to your clients. This article will show you how!

December 9, 2010
by Sheryl Rowling, CPA, PFS

In today's difficult economy, clients are concerned with saving money in any way possible. Certainly saving money on taxes is at the top of the list it's a way to save money without impacting lifestyle. As their trusted CPA, you are careful to advise your clients on tracking tax deductible expenses, avoiding Alternative Minimum Tax and planning at year-end. Yet, you've probably shied away from advising on tax efficient investment strategies. However, advising on tax saving investment strategies does not mean you need to be a registered investment advisor; it just means that you need to know the strategies. And that is what I will cover in this article.

Tax savings, in the context of investing, can be broken down between temporary savings and permanent savings. Temporary tax savings merely postpone tax. Permanent savings decrease taxes without any reversals in future years.

Temporary tax savings provide benefits from the compounding value of tax deferral coupled with clients' typical aversion to paying tax. A word of caution: The integrity of investment strategy should not be compromised only to generate temporary tax savings.

Unlike temporary tax savings, permanent tax savings might justify some deviation from investment strategy. For example, it might be worthwhile to postpone a trade by a few weeks if it will convert a short-term gain to a long-term gain.

Sheryl Rowling will be speaking on this topic at the Advanced Personal Financial Planning Conference. Join us from January 9-12, 2011 in Las Vegas. Early registration ends for the conference on December 17, 2010!

As a CPA, there are two primary ways of helping your clients manage their investments for greater tax efficiency:

  • You can review their tax returns for opportunities.
  • You can proactively plan with clients.

Reviewing Tax Returns for Opportunities

Take a look at your clients' tax returns. They provide clues that can lead to tax savings. Specifically, you want to look at the following forms and schedules:

  • Schedule B
  • Schedule D
  • Form 6251
  • State Tax Return

Schedule B: Does Schedule B (or page 1 of Form 1040) show tax-exempt interest or dividends?

Municipal bond interest rates are generally set to benefit those in the highest tax bracket. If your client is in a low tax bracket, non-municipal bonds, such as Treasuries or corporate bonds may be best. If your client is in a high tax bracket and Schedule B (or page 1 of Form 1040) doesn't show tax-exempt interest or dividends, you might want to suggest municipal bonds.

Saving tax dollars by investing in municipal bonds results in permanent tax savings.

Schedule D: Are there short-term gains from sales of securities? Are there significant gains reported? Have losses been reported from sales occurring only at the end of the year?

If short-term gains have been recognized, you should look at the related holding period(s). Sales of securities held almost a year should have been postponed in order to convert the short-term gains to long-term.

Delaying sales to create long-term gains rather than short-term gains can result in permanent tax savings.

If significant gains have been reported, you might want to look at how the cost basis was determined. Selling high cost lots first (specific identification) will minimize your client's recognized gains.

Selling high cost lots, as opposed to FIFO or average cost, will produce temporary tax savings.

If losses were claimed solely from year-end sales, it means that harvesting losses throughout the tax year could be beneficial. Tax loss harvesting seeks to sell positions in a taxable account solely to recognize a tax loss. Because of the wash sales rule (substantially identical securities cannot be purchased in any of the taxpayer's accounts within 30 days of the loss sale), to maintain the integrity of the client's investment strategy, the client should purchase an appropriate substitute position to be held during the interim period.

Tax loss harvesting produces temporary tax savings.

Form 6251, Alternative Minimum Tax: If the client is subject to Alternative Minimum Tax, is municipal bond interest or dividends added as a preference item?

Some municipal bonds, including certain private activity bonds, are subject to Alternative Minimum Tax. If your client is affected by this, you might advise them to consider municipal bonds that are tax-free for Alternative Minimum Tax purposes.

Holding municipal bonds that are exempt from Alternative Minimum Tax, as opposed to those that are not exempt from Alternative Minimum Tax, can result in permanent tax savings.

State Tax Return: Does the client report income from municipal interest or dividends on the state tax return?

If municipal bond interest or dividends is taxable for state purposes, it means that the client's municipal bonds are not "in-state." Suggest that the client invest in resident state municipal bonds.

Investing in resident state municipal bonds, rather than other state(s) municipal bonds, can result in permanent tax savings.

Proactive Planning

Proactive planning involves forward-thinking on all of the above items. Additionally, you might discuss "location optimization" with your clients.

Location optimization seeks to hold positions in "optimal" account locations, when possible, in order to maximize tax efficiency. Location optimization can only be applied when rebalancing at the household level, i.e., across accounts. In an ideal world, investments generating ordinary income should be held in retirement accounts to avoid current taxation. Investments held primarily for long-term appreciation should be held in taxable accounts in order to take advantage of capital gains rates and/or basis step-ups at death. And, investments generating high expected long-term returns should be held in Roth IRAs since these returns will avoid tax altogether.

Final Words

Tax-efficient investing requires effort on the part of the CPA and the client's investment advisor as well as understanding on the part of the client. However, tax efficient investment advice can help create more loyal clients and differentiate your services from the competition. In the end, your practice will benefit and your clients will save money!

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Sheryl L. Rowling, CPA/PFS, CEO of Total Rebalance Expert(R) and Partner of Moss Adams Wealth Advisors LLC, has been providing fee-only tax and financial planning advice since 1979. Sheryl has been named one of the nation's top 250 financial advisors by Worth magazine, one of the country's most influential CPAs by CPA Magazine and one of Accounting Today's 100 Most Influential People.

The AICPA's Personal Financial Planning Section is the premier provider of information, tools, advocacy and guidance for CPAs who specialize in providing estate, tax, retirement, risk management and investment planning advice to individuals and closely held entities. All members of the AICPA are eligible to join the PFP section.  Don't miss the Advanced PFP Conference at the Bellagio in Las Vegas Jan. 9-12, 2011 with a robust agenda tackling the latest issues and a special day-long session on implementing PFP in a tax practice.  The Personal Financial Specialist (PFS) credential is exclusively available to CPAs who wants to demonstrate their expertise in this subject matter. If you are Series 7, 65, or 66 licensed, you have until 12/31/2010 to use that license as one of the qualifications to obtain the credential.  Visit www.aicpa.org/PFP to learn more.