"You must pay your taxes. But, there's no
law that says you gotta leave a tip."
–Morgan Stanley advertisement
As the relief of tax season fades into the deep corners of our memory, many taxpayers may be sitting back thinking they’re done; they’ve successfully filed their taxes so they can relax and (hopefully) wait for that refund to hit their account. Before you start putting your legs up and planning that summer vacation, remember that if you are not careful you may inadvertently be giving away your hard earned money to the IRS by delaying in planning and preparing for next year’s return.
At Kabarec Financial Advisors, Ltd. (KFA), we are routinely tax planning for our clients to generate tax alpha - the value-add that an advisor provides by implementing “proactive tax strategies that generate tax savings, particularly in a portfolio (where the larger the portfolio, the larger the potential tax benefits).1 As reputable sources like Vanguard, Morningstar and Envestnet point out, strategic tax planning is worth 0.70% to 3%in annual tax alpha, and that estimate does not include the potential benefits of income tax planning, such as tax bracket management - the process of strategically managing your controllable income in conjunction with marginal tax rates to improve overall tax efficiency. We consider the following high level strategies for all of our clients:
Asset Location– Vanguard research shows that asset location can provide clients with up to 0.75% of additional annual return2. Asset location is a tax minimization strategy that locates investments based on two primary factors: an investments tax-efficiency and its expected returns. For example, placing traditionally high growth and high turnover assets, such as emerging markets and sector rotation fund in the tax-free Roth, or sheltering investments that generate high ordinary income, such as taxable bonds in a tax-deferred IRA. A good asset location reference is Chart 1, “the full asset location smile and the asset location priority list” from The Kitces Report, “Advanced Concepts & Strategies in Asset Location”. In addition, asset location is most effective when the strategy is implemented at the “household level” versus at the account level. Therefore, when considering an asset location strategy for your investments look for firms (like KFA) that can diversify your investments at the “household” level.
Source: Michael Kitces, The Kitces Report
Municipal bonds– One of the principal assumptions of an effective asset location strategy is to use taxable bonds in tax-deferred accounts. However, in certain situations where the tax-deferred accounts are not large enough to properly diversify a client’s investments between stocks and bonds, tax-exempt municipal bonds are a good option. In addition, when considering municipal bonds in a taxable account, investors should review their tax bracket to determine if tax-exempt municipal bond yields are comparable to U.S. Treasuries. For example, 10-year AAA municipal are currently at 1.32 relative 10-year U.S. Treasury bonds, and the tax equivalent yield for a 15%, 28% and 35% tax brackets are 2.03, 1.83 and 1.18 relative to 10-year U.S. Treasury bonds. Table 1 shows the comparison of the U.S Treasury Yield Curve to the AAA Municipal Yield Curve.
Tax loss harvesting– Tax loss harvesting is the strategy of selling securities at a loss to offset a capital gains tax liability, without permanently changing the underlying investment/portfolio. Evestnet’s “Capital Sigma: The Return on Advice” shows that a properly tax managed portfolio may be worth 0.60% annually over a buy-and-hold portfolio.3 Investors should be aware that Congress has passed a 30 day “wash sale” to limit potential abuses. The wash sale rule requires that a tax loss can only be claimed by investor’s if the replacement investment is not “sustainably identical”. In addition, investors should note that tax loss harvesting may trigger a future gain, and thus the value of tax loss harvesting is really in the tax deferral of the loss from time originally claimed until the recovered loss is triggered. For example, an investor buys a stock for $10,000 and its value declines to $6,000. The investor can harvest a $4,000 tax loss, but in doing so, the investment will now have a cost basis of $6,000. When the client sells the stock for $10,000 (the original purchase price), the investor’s gain will be $6,000 (so the net gain is $0). 1
Income Tax Planning– The 3rd and 4th quarter of every year, KFA helps clients’ tax plan going into the end of the year. This includes running illustrations to help minimize a client’s tax burden. We use various strategies, including harvesting gains, tax bracket maximization strategies such as Roth conversions or retirement withdrawal ordering optimization, charitable giving and gifting strategies, and the classic tax deferral strategies (e.g. IRA’s). As Michael Kitces points out, “the tax bracket arbitrage opportunity… is often the biggest tax planning opportunity available”, but it is difficult to quantify.1
Kitces, “Evaluating Financial Planning Strategies and Quantifying Their Economic Impact” The Kitces Report, Volume 3, 2015.
Kinniry Jr, Jaconetti, DiJoseph, Zilbering, Bennyhoff, “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha”, September 2016.
Envest PMC’s Quantitative Research Group, “Capital Sigma: The Return of Advice”, 2016.
By: Lisa Thuer - Senior Trading and Research Specialist
What a contrast from how last January started. It is almost the reverse of stocks that were down last year are up this year. As we have stated before, last year was a difficult year to navigate. You may ask yourself, won't this year be just as difficult with the new regime now in office? What happens now and where do we go from here?
Earnings season is upon us and corporate earnings have thus far been positive. Businesses are optimistic with potential tax cuts, infrastructure spending, employee benefit costs and reduced regulation. Bringing earnings back from overseas would be a bonus for shareholders and the stock market. However, this all takes time and we still need to keep both hands on the wheel. We know in the political world not everything gets done as planned nor as fast as we would like it to.
So regardless of your views on our current Commander-in-Chief, we still want America to succeed and we are all Americans. We all want our portfolios to increase regardless of who is in office. Now with all the election noise behind us and some will probably continue, we are moving forward. Towards the end of last year we started adjusting investments going into 2017. There will be additions to current holdings and reducing others. We still continue to like dividend payers, technology, consumer discretionary, financials (regional banks), and small companies. We will continue to hold alternative investments, however we will be reducing our holdings and allocating funds towards growth or income based the portfolio. As stated above, we will remain diversified and weather the storms and the tweets.
As always, do not hesitate to contact us should you have any questions or would like to come in and meet with a KFA team member.
By: Lisa Thuer - Senior Trading and Research Specialist
We are a week away from a historical Presidential Election. A new twist seems to take place on a daily basis in both camps of Clinton and Trump. Unfortunately the market does not like the uncertainty that is taking place. These volatile times make investing in the near term a very difficult time to deal with the volatility and the fear of the unknown. Each candidate has their own agenda. How much they will be able to get done in Washington also depends on if we remain a balanced government with Congress or if it will be one-sided. Approaching Election Day, we thought it would be clear as to which direction the markets will be heading. However, everyday there seems to be a new headline leading to more uncertainty.
Healthcare has been a drag on our portfolios this year. It is one sector that had been hit hard at the beginning of the year and was not able to bounce back as other sectors did. The healthcare sector is filled with innovation and advancements allowing people to live longer and cures for cancer and other diseases to name a couple. Baby boomers and our aging population are all benefiting from the advancements taking place in this sector. Unfortunately, the elections are wreaking havoc in this area and the regulations that may be implemented are unknown. We have made a decision to reduce the risk going into the Election next week by taking healthcare off the table. Pharmaceuticals and Biotechnology will continue to be volatile in the coming months. We still believe this is an area of growth in the future; however we will sit on the sidelines and wait for all the regulatory issues to fall in place.
The rest of our portfolio will remain invested in the current asset allocation of stocks, bonds and alternatives and we will not make any further changes until after the Election. Even with the volatility that will take place in the coming days and weeks, it is built to weather the storm. The talk has been swarming that there will be a tax repatriation holiday where multinational companies will be able to bring back foreign profits to the U.S. at a favorable tax rate. This would benefit the U.S. and us as investors by encouraging the corporations to spend and create jobs along with a possible one-time special dividend to shareholders. Therefore we are willing to be patient in the remainder of our portfolio and do not want to be out of the markets when this does take place.
In the meantime, we appreciate your confidence and support through these difficult market times. Should you have any questions, please feel free to contact one our KFA team members.
The path to reaching your financial goals will have low points and high points. It is essential to always look forward and ask for help when needed. At KFA we can help you understand the whole picture, helping you prioritize your goals and find your risk and reward balance in your portfolio. In the coming days we are looking to add further diversification to most of our portfolios. We are analyzing dividend payers that operate as islands of calm in a volatile market. Most portfolios have already added alternative investments and dividend paying stocks. We will continue to seek quality investments over all else in this era of volatility. Should you have any questions please feel free to contact us.
An oily arrow from Cupid struck the market today as the DOW Jones Industrial Average finished up over 300 points. Oil and the market have been in lockstep this year, tripping and falling down the aisle in harmonious disappointment. Traditionally, market volatility blushes in comparison to oil volatility. According to Barclays, the correlation between oil and the market amount to 25% over the past two decades. In 2016, the narrative has been different as oil and the market have created a Thelma and Louise couple. Panicked investors are getting what they settle for as they drive off the cliff of sanity.
Ever since oil fell under $40 dollars per barrel in December the US equity market has been pushed downward. Investor confidence jumped off a cliff in holy matrimony with oil. Barclay’s 25% correlation number does not pertain to our current situation. The below graph illustrates how oil and equity prices have tangled downward, hand in hand, since December 7th. The contemporaneous correlation between Brent Crude Oil and the S&P 500 is unbelievably high at 91.39%, stunningly comparable to the correlation between US GDP growth and the S&P 500.
(Cumber Asset Correlation Group)
For the past two months, the market has endured an emotional correction. Retail sales in January were up, posting a third consecutive month of gains. When you exclude gas stations, retail sales have posted gains seven months in a row. Full-time employment grew by 2.5 million jobs as part time employment shred 120,000 jobs. The best news for a college student? There are 5.6 million jobs that remain unfilled in the US economy. The Fed targeted a 2% core inflation target and year to year we sit at 2.1%. Historically, GDP Growth and the S&P 500 have been the Romeo and Juliet of correlations. At KFA, not only do we endear classical beliefs about the economy but we also choose wisdom over short-sightedness.
Valentine's day weekend aside, we are keeping an eye on every economic indicator. The media has been spewing the word "recession" without first consulting a dictionary. A recession is defined as a fall in GDP growth after two successive quarters, our GDP has not experienced a fall since 2009. Nearly every economist forecasts a rise in GDP for the 4th quarter of 2015 and another rise in the 1st quarter of 2016. What we seem to be experiencing is an emotional correction and not a long term trend.