Most people view tax season as the time leading up to the April 15th tax date (well, April 18th for 2011). But here at Pinnacle, our tax season begins much earlier as we prepare portfolios for the end of the year. The Wealth Managers and I have been working for the past few weeks, and will continue to do so throughout the remainder of the year, analyzing gains and portfolio construction to ensure proper tax management.
There are a multitude of tax issues that we handle as we believe this is an important part of the process here at Pinnacle. We contact all mutual fund companies in which we invest to get an estimate on pass through gains. If the expected pass through gain is very large we stop making new purchases into the fund in the weeks leading up to the distribution. With the Great Recession a few years in the past, most mutual funds have losses to offset the gains but we have identified a few funds with modest distributions this year.
Then we review realized gains and loss statements for each client. The information we have available pertains to only accounts managed at Pinnacle. If a client has a large realized gain for the current year we will start the tax loss realization process. The investment team first identifies any security with a loss across the books, and then we finish with a client specific search for losses. For one month, due to the wash sale rule, we will purchase a proxy security with the expectation to switch back at the beginning of the New Year.
We can also search these reports for the past few years to see if there are carry-forward losses. If there is a large gains estimate for the current year, after accounting for carry forward losses, we will typically sell any current position with an unrealized loss (if there are any) to reduce the realized gain, assuming we can find a suitable proxy security to serve as a temporary replacement.
Additionally, if there are large carry forward losses from the past few years, as there may be due to the 2008 bear market, we will analyze the tax hierarchy of our model portfolios. Our tax hierarchy is built to rank the tax sensitivity of all securities owned in our models. The tax hierarchy is programmed into our portfolio trading software so that tax inefficient securities are bought in tax deferred accounts and tax efficient securities are bought in taxable accounts. We analyze the portfolios to see if there is any inconsistency between the tax hierarchy and portfolio construction (which can sometimes occur as we make changes to the models throughout the year), and sell securities in taxable accounts to re-purchase them in tax-deferred accounts, if it makes sense. When there are carry forward losses this is a much easier process because we can sell securities with gains.
Our tax process also deals with Required Minimum Distributions (RMDs). There are a few clients who receive monthly payments from their IRAs to satisfy the requirement but generally speaking the bulk of our clients wait until year end. We again analyze the tax hierarchy to sell the position inside the deferred account with the most beneficial tax treatment. We do this because the money distributed from the IRA is moved to the taxable account and we re-purchase the security back to keep the account on our managed model. If the distribution leaves the managed group we simply rebalance the portfolio taking into account the distribution.
I could go on, but I think I have given you a little insight into the tax planning that occurs at Pinnacle. I am sure to be busy over the remaining few weeks of 2010.
