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With April 15 a very recent memory, taxes are probably still fresh on your mind. Most clients I've talked to have been rather unpleasantly surprised that they haven't seen much, if any reduction in their income taxes.

This situation is especially true for folks living in states with high state income tax rates and steep real estate taxes such as California, New York and Illinois as the State and Local Tax (SALT) deduction is now capped at $10,000.

While the tax reform that was instituted in 2018 did help many small business owners by providing a 20% tax deduction for “pass through” businesses, most law firms did not benefit from the reform, since many service businesses get phased out from this deduction.

Furthermore, I've heard it said before that lawyers make their money in about the least tax-friendly way possible. Think about it: All your income is taxed as ordinary income. Your private business owner clients have the luxury of building and eventually selling their companies and paying the lower, more favorable long-term capital gain tax rate. Not so for you, counselor.

So, if the changes to the tax code have left you wondering what you can do to be smarter from a tax perspective, consider these concepts. When it comes to investing, two of the great robbers of long-term returns are fees and taxes.

Fortunately, as an investor you can exert some degree of control over both these factors. You can control the fees you pay by seeking out lower cost, more passively managed mutual funds or ETFs to construct your portfolio. On the tax side you can build and manage your portfolio in a way that solves for a better after-tax return. After all, it's not what you make, but what you keep that really counts. Here are a couple of practical tips to keep in mind:

Location, location, location

As they say, the first, second and third rules of real estate are location, location, location. Where your property is located matters more than almost anything. The same can be said of your investments. The type of account in which you hold your investments will greatly impact its long-term after-tax return. This concept is referred to as “asset location” or “asset placement.” The concept is straight-forward, but often overlooked by not only individual investors but also professional advisers. Here's how it works:

Let's start with the two basic types of investment accounts: 1) taxable brokerage accounts and 2) tax-deferred retirement accounts such as 401(k)'s or IRAs. It is better from a tax standpoint to own certain types of investments in taxable brokerage accounts and other assets in retirement accounts.

Oftentimes investors think that they should hold their fastest-growing, highest returning investments such as stocks in their IRA or 401(k) since they don't plan to access those accounts for many years. This seems logical. However, from a tax standpoint it is flawed thinking. Here's why: IRAs and 401(k) accounts are composed of dollars that have never been taxed. Eventually Uncle Sam forces you to take your money out of those IRAs and 401(k)s, and when you do, the money comes out as ordinary taxable income.

So, if you put your highest growing assets into your retirement accounts you are creating a bit of a tax time bomb for yourself in the future as you are forced to take money out of those retirement accounts and pay full-freight ordinary income tax.

Instead, it's smarter to put your slower-growing, income-producing assets such as bonds and real estate funds in your tax-deferred accounts, which creates two benefits. First, you are creating less of a tax liability in the future since bonds do not grow as fast as stocks. Second, the income that those bonds pay each month will not be taxed since they are held inside your tax-deferred accounts.

In your taxable accounts is where you should own your higher return potential investments such as stocks. To be even more tax savvy you can invest in stock mutual funds that are specifically managed for after-tax return or ETFs and index funds which are naturally tax friendly.

One really important caveat to this concept of “asset location” or “asset placement” is that it assumes you have assets in both taxable and tax-deferred accounts. If your 401(k) is your only investment account, then you should still make sure you are properly diversified with a mix of stocks and bonds in order to meet your long-term investment goals.

Make Lemonade Out of Lemons

Nobody likes when their investments go down in value. It's an unsettling feeling to watch the stock you bought for $10,000 now worth $8,000. On paper you've just lost $2,000. The fourth quarter of 2018 was full of examples like this in which investors were staring at their declining portfolio values a bit paralyzed and shocked.

While your portfolio losing value is of course disappointing, it can also present an opportunity to do something smart from a tax perspective. The concept is called “tax loss harvesting,” and it enables investors to make a bit of lemonade out of the lemons of tough markets.

Here's an example of how it works: Let's say you invested $20,000 in a mutual fund a couple of years ago, and it has now dropped in value to $16,000. We'll call this “Fund A.” You can do nothing and hope that Fund A goes back up over time.

On the other hand, you could sell Fund A and “harvest” that $4,000 loss. This $4,000 capital loss can be used in the future to offset capital gains you might have in future years, thus lowering the amount of capital gain tax you'd have to pay. In addition, when you sell Fund A you could buy a similar fund (let's call it “Fund B”) with the proceeds from your sale so that you continue to stay invested in the market. Thirty days later, you can sell Fund B and go back into Fund A so that you are back to your original investment, but meanwhile you have “harvested” that tax loss which can be an asset to you in the future.

One important note: It's critical that you wait a full 30 days before going back to your original investment in order to avoid violating something called the “wash-sale rule,” which would disallow your loss. If you have questions about this, you could always consult your tax adviser who should be able to guide you.

As the old saying goes, the only two certainties in life are death and taxes. I can't help much with the former, but hopefully I've provided some practical tips for how to better manage the latter.

Important Disclosure: Investments involve risk, and past performance may not be indicative of future results. Balasa Dinverno Foltz LLC (BDF) investment and wealth management strategy recommendations may not be profitable, suitable or equal historical performance. BDF does not provide tax or accounting advice. Clients of BDF should obtain their own independent tax advice based on their particular circumstances. The information herein is provided solely for educational purposes. BDF's current written disclosure statement discussing advisory services and fees is available for review at www.BDFLLC.com or upon request.

 

Justin Peacock is an owner and wealth manager at BDF, a fee-only wealth management firm based near Chicago with assets under management in excess of $4 billion. BDF serves clients nationwide and Justin provides financial planning services specifically tailored to addressing the distinct needs of lawyers. He can be reached at [email protected].